Derivatives, Bankruptcy and Lehman
During the past 18 months, the world has felt the impact of derivatives on financial markets. Many businesses have for years used derivative contracts such as currency or interest rate swaps or forward contracts for the purchase of oil, gold, natural gas, wheat or other commodities to hedge their exposure to an unexpected rise or fall in values, interest rates or prices. However, the scope and extent of trading in derivative instruments exploded during the past 10 years, causing profound effects on the world’s financial markets.
In fact, the Bank for International Settlements, the central bankers’ bank located in Basel, Switzerland, estimated that the total notional value of global derivative contracts had risen to $516 trillion as of June 2007, just before the failure of two Bear Stearns hedge funds signaled the beginning of the current financial crisis.
Many derivatives were, and continue to be, traded on public exchanges such as the New York Mercantile Exchange (NYMEX), but the overwhelming majority of these transactions are “over the counter” (OTC) trades negotiated directly between private parties that are exempt from regulation by the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC) or other governmental regulatory bodies.
In some cases, interest rate swaps or other derivative transactions are included within complicated structured finance transactions involving special purpose vehicles that were sold to investors as “safe” and given triple A ratings by one or more ratings agencies.
The September 2008 collapse of Lehman Brothers Inc. and its affiliates “opened the kimono” to the nature and extent of global derivative trading and the use of such transactions in other structured finance deals, and heightened awareness of the tremendous impact that the collapse of a significant player in the derivatives market can and did have on worldwide financial markets.
Today, 15 months after the first Lehman bankruptcy case was filed, Lehman is still affecting the derivatives markets, albeit in a very different fashion. Through bankruptcy court adversary proceedings and motion practice, Lehman and its former trading partners (counterparties) are creating precedent that may change the way future derivative contracts are negotiated and the way other investments are structured.
In addition, these proceedings and motions will provide some guidance to litigants navigating the murky waters at the edges of the Bankruptcy Code’s securities and derivative “safe harbors.” This article will discuss the Code’s safe harbors and some of these ongoing proceedings.
The Safe Harbors
To understand the Bankruptcy Code safe harbors, it is useful to understand the effect that a bankruptcy case typically has upon persons or entities engaged in transactions with a debtor.
The filing of a bankruptcy petition is a watershed event that creates an estate consisting of all of the debtor’s rights and interests in property, including contract rights. With some notable exceptions, the Code prohibits a non-debtor counterparty from exercising any rights and remedies against the debtor or its property or from continuing litigation against the debtor.
The debtor in possession or the bankruptcy trustee also is vested with certain rights and powers, such as a qualified right to assume, reject, or assume and assign unexpired leases and other types of contracts to which the debtor is a party where some performance by both parties remains due (executory contracts).
To facilitate a debtor’s ability to retain and/or realize value from its pre-petition contracts, the Bankruptcy Code renders certain types of contract provisions unenforceable, such as anti-assignment clauses and clauses that permit a party to terminate a contract based on a debtor’s insolvency or the filing of a bankruptcy case (so called “ipso facto clauses”).
These provisions, and many others like them in the Code, are purposefully designed to provide the debtor:
- breathing room to assess its situation;
- a means to delay or prevent the forfeiture of valuable property and contract rights;
- a way to collect and sell its assets;
- the opportunity to take the steps necessary to reorganize;
- the ability to obtain performance from its counterparties in spite of existing defaults;
- the ability to undo or avoid certain transactions that benefitted one subset of creditors to the detriment of others.
As a necessary corollary, some non-debtor counterparties may find themselves stuck in limbo for months, and even years, waiting for the debtor to determine whether to assume, reject or assume and assign their contracts, negotiate and confirm a plan, and pay claims.
This delay and uncertainty is difficult for any business but can be particularly problematic for financial markets, which require parties to be able to timely close existing trades in order to engage in new ones. Indeed, many market players engage in back-to-back trading, so the bankruptcy of one market player could result in a cascade of defaults and insolvencies.
To prevent the policies underlying the Bankruptcy Code from disrupting financial markets, the Code has been amended numerous times since it was first enacted in 1978 to include the so-called safe harbor provisions. These provisions are designed to neutralize the impact of a bankruptcy filing upon counterparties. Among other things, the safe harbors:
- permit certain categories of counterparties to terminate existing securities, commodities, forward, repurchase, and swap agreements and master netting agreements relating to these types of instruments (collectively “securities and derivative contracts”);
- exercise contractual, exchange-specific or other rights to accelerate, liquidate, terminate or set-off under the parties’ securities and derivatives contracts;
- exempt certain prepetition settlement payments, margin payments and other transfers made in connection with securities and derivative contracts from avoidance as a preference or a constructive fraudulent conveyance when such payments are made to or through certain categories of persons.
In other words, when they apply, the safe harbor provisions protect counterparties to securities and derivative contracts from being subject to the automatic stay, the prohibition against the enforcement of ipso facto clauses, avoidance claims and many of the other special protections afforded to debtors.
In the Lehman case, tens of thousands of non-debtor counterparties took advantage of the Bankruptcy Code safe harbors to terminate their ongoing securities and derivative contracts with Lehman during the days and weeks after the bankruptcy filing. Many other such transactions appear to have terminated automatically, in accordance with their terms, when the particular Lehman counterparty or credit support provider filed its petition.
Less Routine Issues
Certain counterparties, however, did not terminate their securities and derivative contracts with Lehman. In at least some of these cases, it appears that termination would have resulted in a net payment to Lehman, i.e., Lehman was “in the money” on those trades. So those counterparties may have waited to see what happened in the market before incurring a present liability.
Others have terminated, but not made payments to Lehman based on “walkaway” clauses in their agreements, the default resulting from Lehman’s filing or because Lehman itself failed to perform post-petition.
There is no question that the safe harbors do not apply in every case. The counterparty seeking to exercise rights under one of the safe harbors must qualify under one or more of the definitions set out in the Bankruptcy Code, the transaction itself must qualify for such treatment, and the right exercised must be of a type protected by the safe harbors.
Although the facts are different in every case, certain of these issues have been litigated before and thus there are decisions that provide some guidance to parties in determining how to act when their counterparties become debtors. However, until now, there have been very few decisions directly dealing with the effect of time, i.e., does there come a time when a party can be deemed to have waived its right to terminate so that the safe harbors are no longer safe?
And, assuming that waiting is an option, can the counterparty rely on the bankruptcy as a default that excuses ongoing performance due to the debtor?
Likewise, the enforceability of walkaway clauses or other provision that have the effect of subordinating the debtor’s right to payment in the context of securities and derivative contracts has been and remains an open question.
The following discusses some of the recent rulings, motions and proceedings pending in the Lehman case that bear on these open issues.
Waiting Does Not Always Pay
In spring 2009, Lehman Special Financing Inc. (LBSF) filed a motion to compel one of its counterparties, Metavante Corporation, to perform under an interest rate swap that the parties had entered into pre-petition.
The contract contained a quarterly net payment schedule, by which only the net obligor was required to make a payment in any given month. Lehman Brothers Holdings Inc. (LBHI) was the credit support provider.
Apparently, the parties did not dispute that, but for the default resulting from Lehman’s bankruptcy, Metavante would have owed Lehman quarterly net interest payments as it was the net-obligor for each post-petition quarter.
After the bankruptcy cases were filed, Metavante did not terminate the swap. It also did not make the quarterly payments, claiming that the LBHI Chapter 11 filing was a default that excused its obligation to make payments under the terms of the 1992 ISDA Master Agreement that governed the transaction. Metavante also argued that the Bankruptcy Code’s safe harbors permitted it to wait to terminate, and in the meantime, to withhold performance.
The bankruptcy court disagreed, and in so doing made several important holdings:
- First, it held that even though the swap at issue qualifies under the Bankruptcy Code safe harbors, it is an executory contract.
- Second, while the safe harbors protect a counterparty’s right to terminate, liquidate, accelerate and set-off amounts due under its securities and derivative contracts with a debtor, the safe harbors do not permit such a party to withhold performance while the transaction is ongoing even if the debtor is in default, and the Bankruptcy Code trumps any state law that might otherwise permit such a result.
As such, since Metavante didn’t terminate the swap, it had to perform post-petition despite the fact that the Lehman bankruptcy filings constituted a default under the agreement.
- Third, the bankruptcy court found that while the safe harbors don’t require the counterparty to terminate, Metavante’s failure to do so a year after the filing constituted a waiver of its rights to do so in the future. The bankruptcy court did not indicate a specific time by which termination must occur, but read the applicable Bankruptcy Code sections and legislative history to require the counterparty to take action “fairly contemporaneously with the bankruptcy filing.”
- Finally, the bankruptcy court held that Metavante’s failure to perform (i.e., pay amounts due) under the swap was a violation of the automatic stay, and directed Metavante to perform while Lehman determined whether to assume or reject the parties’ swap agreement. Id. In subsequent rulings, the bankruptcy court denied Metavante’s motions to alter or amend its ruling and to stay the effect of the ruling while Metavante’s pending appeal is decided.
A copy of the transcript of the Metavante ruling is available at www.lehmancreditors.com.
In another series of pending motions and adversary proceedings, Lehman has challenged the enforceability of contract provisions that eliminate termination payments (a “walkaway”) or otherwise change the priority of payments that might otherwise be due to Lehman when the securities or derivative contract was terminated as a result of a Lehman bankruptcy or certain other events of default.
These types of provisions typically were included in structured swap/credit derivatives and other types of transactions between institutional counterparties and special purpose entities set up by Lehman; they may have been included to satisfy certain rating agency requirements.
While the facts and terms of each transaction are different, in each of these cases Lehman has argued that the walkaway clauses are unenforceable ipso facto clauses not encompassed by the safe harbor right to terminate, accelerate, liquidate and set-off under a securities and derivative contract. The counterparties generally have argued that walkaway and subordination clauses are part and parcel of the liquidation provisions under these securities and derivative contracts and thus are enforceable under the Bankruptcy Code safe harbors.
By contrast, Lehman has taken the position that the safe harbors protect only a limited right to liquidate, i.e., calculate the amount due, but not to actually give effect to the payment structures set out in the contracts. These issues are complicated by the fact that in many cases, the direct counterparty to the transaction is a special purpose vehicle that may or may not have assigned its rights to a trustee acting on behalf of the underlying investors who are the real parties in interest.
The bankruptcy court has not ruled as to whether walkaway or subordination provisions in securities and derivative contracts are protected by the safe harbors, but a ruling on this issue may result from one of the pending summary judgment motions in these cases.
Reverse Pay to Play
Since the Metavante motion was filed, Lehman has sought to apply the same arguments to compel performance by counterparties to other non-terminated securities and derivative contracts.
In response, some of these counterparties have argued that, unlike the situation in Metavante, where the default resulted solely from the bankruptcy filing and the parties’ contract only required payment by the net obligor, they were not obligated to perform because Lehman is in default post-petition for failure to make its required payments post-petition.
In effect, these counterparties have sought to stand Lehman’s Metavante argument on its head, claiming that Lehman must likewise “pay to play” where the parties’ agreement does not provide solely for a net obligor payment as was the case with Metavante, and thus should not be permitted to ride the market until conditions turn in its favor. At a minimum, the counterparties claim that Lehman must pay outstanding sums due post-petition and the counterparty should be granted adequate assurance that Lehman likewise will perform (i.e., pay) its obligations on outstanding swaps in the event of a credit event that would result in a payment to the counterparty in the future.
In another variation, the counterparty argued that while a debtor is not required to perform its duties under an executory contract post-petition, the debtor also cannot compel a counterparty’s performance without paying for such performance. Since Lehman had not made any payments to that counterparty since it filed for bankruptcy protection, the counterparty asserts that the motion to compel should be denied.
At a recent argument dealing with one of these motions to compel and Lehman’s companion motion to dismiss the counterparty’s adversary proceeding, the bankruptcy court noted that the cost to Lehman of performing was very low, and suggested that a settlement could be worked out on that basis. The implications of such an agreement may be problematic for Lehman, however, particularly if other counterparties demand the same type of post-petition performance.
If upheld on appeal, the Lehman court’s Metavante decision is likely to have a significant impact on a counterparty’s decision whether and when to terminate outstanding securities and derivative contracts at the outset of a bankruptcy case.
At a minimum, an “out of the money” counterparty will be faced with a difficult choice: terminate immediately but possibly have to make a significant termination payment to the debtor, or let the contract ride in the hope that the market turns quickly, but have to perform post-petition in the meantime.
Indeed, this choice is very much “heads I win, tails you lose” for the debtor, because even if the market does turn in favor of the counterparty, the debtor likely will reject the contract, leaving the counterparty with nothing more than a large, pre-petition rejection damages claim.
Nevertheless, the impact of the Metavante decision may be tempered if the court agrees that the debtor must “pay to play” post-petition, particularly where the debtor and the counterparty have many outstanding transactions and performance by both parties is required.
So too, the bankruptcy court’s construction of the “walkaway” clause (present in many negotiated securities and derivative contracts) may influence parties in future negotiations, particularly if the court holds that such clauses are not enforceable when one side is in bankruptcy.
As more of these issues are litigated, the Lehman bankruptcy case likely will provide at least one court’s answer to some of the many open questions regarding the extent and reach of the Bankruptcy Code’s derivative safe harbors.
Reprinted with permission from the Dec. 14, 2009, issue of the New York Law Journal, Corporate Restructuring & Bankruptcy special section. © 2009 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.