Recent Ruling by Lehman Court Further Complicates Law on Derivatives

Decisions emerging from the Lehman Brothers chapter 11 cases are helping to define the parameters of the Bankruptcy Code’s safe harbors for derivative transactions (see Bankruptcy and Creditors’ Rights Alert,January 28, 2010). One ruling of note is the Bankruptcy Court’s recent decision in an adversary proceeding pitting Lehman against BNY Corporate Trustee Services (BNY) in its capacity as Indenture Trustee for certain credit-linked synthetic portfolio notes (the “Notes”). A Lehman-formed special purpose entity called Saphir Finance Public Limited Company (Saphir) was the issuer of the Notes and also was a party to a swap transaction with Lehman Brothers Special Financing (LBSF) in connection with the Notes transaction. The litigation involved competing claims by LBSF and the underlying Noteholders to certain collateral held by BNY, and the enforceability of a subordination clause (referred to as the “Noteholder Priority”) that purported to assign the Noteholders priority in the collateral over LBSF. The Bankruptcy Court’s decision makes new law as to the enforceability of contractual provisions that purport to change payment rights under a derivative contract as a result of a bankruptcy filing by a party or its credit support provider. The outcome also conflicts with a decision issued by the English High Court in companion litigation between Lehman, BNY and the underlying bondholder that currently is pending in England.

The Safe Harbors

When a debtor files a bankruptcy petition, an estate consisting of all of the debtor’s rights and interests in property, including contract rights, is created. With some notable exceptions, the Bankruptcy Code prohibits a non-debtor counterparty from exercising rights and remedies against the debtor or its property, or from continuing litigation against the debtor once the bankruptcy case is filed. Also, to facilitate a debtor’s ability to retain and/or realize value from its pre-petition contracts and to prevent forfeiture of valuable rights, the Bankruptcy Code renders certain types of contract provisions, such as those that cause a forfeiture of the debtor’s rights or 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”), unenforceable.

These types of protections are designed to prevent the forfeiture of valuable rights by the debtor. As a corollary, however, non-debtor counterparties may find themselves stuck in limbo while the debtor decides 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. To prevent the policies underlying the Bankruptcy Code from disrupting financial markets, the Bankruptcy 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”)
• permit the exercise of contractual, exchange-specific or other rights to accelerate, liquidate, terminate or set-off under the parties’ Securities and Derivative 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. More importantly, the existence and supposed reach of the safe harbors has come to affect market expectations about the risk associated with certain types of transactions involving derivatives.

BNY, Saphir and the Subordination Clause

In the BNY case, LBSF had priority rights in and to certain collateral held by BNY to secure payments due under the swap and the Notes, unless LBSF or its guarantor, Lehman Brothers Holdings, Inc. (LBHI), defaulted by, among other things, filing a bankruptcy case. If LBSF or LBHI defaulted, the Noteholder Priority provision would come into play and LBSF’s rights in the collateral would be subordinate to those of the Noteholders. Importantly, the Noteholder Priority provision was not included in the ISDA master agreement or schedules describing the terms of the swap that were entered into between Saphir and LBSF/LBHI, but rather was contained in the Notes agreements.

Saphir exercised its right to terminate the swap agreement between Saphir and LBSF in December 2008, and designated LBSF’s October 3, 2008 chapter 11 filing as the relevant event of default. Saphir’s termination of the swap triggered its obligation to redeem the Notes, in turn raising the question as to which group of Saphir’s creditors, LBSF or the Noteholders, had priority in the collateral being held by BNY (the termination resulted in a net payment being due to LBSF).

The Noteholders sought to enforce their rights in the collateral, eventually commencing an action in the English High Court against BNY for a declaration that the Noteholder Priority clause was valid and enforceable. At the same time, LBSF claimed that it had prior rights to the collateral and that the Noteholder Priority was an unenforceable ipso facto clause. LBSF and BNY each commenced adversary proceedings in the Bankruptcy Court to resolve this issue, and LBSF also intervened in the English litigation.

In August 2009, the English High Court ruled in favor of the Noteholders. Among other things, it determined that the Noteholder Priority clause was enforceable under English law and that it took effect on September 15, 2008, the date that LBHI filed its chapter 11 case. This ruling meant that, for purposes of English law, LBSF was not entitled to any priority in the collateral when it filed its own chapter 11 case on October 3, 2008, but the High Court did not purport to consider the effect that U.S. bankruptcy law might have on these issues. The High Court’s ruling was upheld on appeal in November 2009.

While the High Court proceedings were on appeal, BNY and LBSF each filed summary judgment motions in their adversary proceedings in the Bankruptcy Court. In its papers, BNY urged the Bankruptcy Court to defer to the High Court’s rulings, and argued that, in any case, the Noteholder Priority was enforceable under the Bankruptcy Code’s safe harbors. Although mindful of the complexities that would result from a ruling contrary to that issued by the English High Court, the Bankruptcy Court nevertheless rejected BNY’s arguments and ruled in favor of LBSF. In doing so, it made a number of important rulings.

First, the Bankruptcy Court found that the swap agreement between LBSF and Saphir was an executory contract, and that LBSF retained its priority rights in the collateral as of October 3, 2008, the date it filed its bankruptcy case. The Court based this holding on the fact that the swap agreement did not contain an automatic termination clause: since it did not terminate automatically, the swap continued in effect despite the filing of the LBHI and LBSF chapter 11 cases until Saphir sent its termination letter on December 1, 2008.

Second, even if the swap had terminated automatically on LBHI’s petition date, September 15, 2008 (a termination that would be protected by the Bankruptcy Code’s safe harbors), the Bankruptcy Court construed the Bankruptcy Code to bar a forfeiture based on the commencement of “a case” – not just “the case.” In other words, once a debtor is in bankruptcy, the Bankruptcy Code’s ipso facto protections apply to prevent the post-petition forfeiture of its rights whether the counterparty claims a default based on the commencement of the particular debtor’s bankruptcy case or the commencement of another debtor’s case. Although it recognized the “can of worms” opened by its finding that ipso facto protections can be triggered by the filing of another entity’s chapter 11 case, the Bankruptcy Court declined to provide guidance as to what kind of debtor to debtor relationship would trigger such protection.¹ As such, the Bankruptcy Court found that, irrespective of whether it was triggered by LBSF’s filing or the earlier filing by LBHI, once LBSF was in bankruptcy, the Noteholder Priority was unenforceable as an ipso facto clause and any effort to enforce this provision would violate the automatic stay.

Third, the Bankruptcy Court found that the Noteholder Priority was not an act protected by the Bankruptcy Code safe harbors. The clause itself neither appeared nor was referred to in the ISDA master agreement, schedules or related confirmation that set out the terms of the swap agreement between LBSF and Saphir. Rather, the Noteholder Priority appeared in the Noteholder documents only. As such, the Bankruptcy Court held that while the Noteholder Priority may have dictated how the proceeds of the collateral would be distributed, it did not fall within the specific terms of the Bankruptcy Code safe harbor that permits the post-petition enforcement of clauses relating to the “liquidation, termination or acceleration” of a swap agreement.

While seeming almost like a “gotcha,” this holding actually is important because it signals that the safe harbors should be construed narrowly, limited to their specific terms whether or not the market viewed the swap and Note documents as part of one “integrated transaction.” There also is no certainty that the Bankruptcy Court would have found the Noteholder Priority or any similar provision affecting the distribution of proceeds of collateral to be covered by the safe harbors even if it had been included in the swap agreement itself. In any case, this holding is likely to effect how future agreements are drafted if only to avoid the possibility of a “gotcha” in a future case.

Finally, the Bankruptcy Court also held that the Noteholder Priority clause was not enforceable under section 510(a) of the Bankruptcy Code.² It found that section 510(a) applies to subordination agreements in which the priorities are static from the outset, but does not apply when subordination is triggered by one party’s bankruptcy filing, as was the case here.

Conclusion

Cases involving large financial market participants such as Lehman do not come along very often. When they do, however, the resulting rulings can have a disproportionate impact on financial markets – even changing the ways that transactions are documented to account for potential litigation risks. For example, does this decision and the Bankruptcy Court’s prior ruling (in the Metavante matter) that termination rights are waived if not exercised timely weigh in favor of including an automatic termination provision in the derivative, or is it still better for counterparties to maintain flexibility to terminate? Does it matter if the ipso facto protection can be triggered by another party’s bankruptcy anyway? Should subordination or other provisions that change a party’s right to payment upon termination be included in the schedule to the derivative contract, and if so, will such provisions be construed as falling within the safe harbors?

The Bankruptcy Court’s decision in the BNY litigation reflects the trend of decisions emanating from the Lehman chapter 11 cases, which have interpreted the Bankruptcy Code safe harbors to have a narrow scope. Under the circumstances, market participants may require additional collateral or other types of security to protect them in the event that contractual provisions once thought to fall within the safe harbors are found to be outside their shelter. This, in turn, may increase the cost of derivatives for all parties.

¹ This holding certainly will, at a minimum, affect other pending Lehman adversary proceedings and claim disputes, in which many counterparties have argued that post-petition terminations and other acts relate back to the day that LBHI (the parent company and guarantor of many operating subsidiaries’ transactions) filed chapter 11, even though the actual termination or other act did not occur until after the operating subsidiaries filed their own chapter 11 cases.

² Section 510(a) of the Bankruptcy Code provides that a subordination agreement is enforceable in a bankruptcy case to the same extent that the agreement is enforceable outside of a bankruptcy case.