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Derivatives in Bankruptcy -- part 1

posted by Stephen Lubben

The Lehman Brothers case has surfaced a good number of important and interesting issues concerning the intersection of derivatives and chapter 11. In particular, while the derivatives industry seemed to think that the 2005 creation of massive “safe harbors” in the Bankruptcy Code essentially nullified their need to care about bankruptcy, several counterparties have found themselves drawn into Lehman’s case. No doubt some of the overconfidence in this regard was the result of the simply truth that nobody in the industry contemplated a “big player” like Lehman as the debtor, and the safe harbor provisions were clearly drafted with "Lehman as creditor" in mind.

One issue that has come up a few times in the past week involves the fate of counterparties on swaps that are “in the money” from Lehman’s perspective. These counterparties don’t seem to know what to do – or maybe they have realized that the “safe harbors” don’t give them the windfall they had hoped for.

For example, the Chicago Board of Education has filed an adversary proceeding to stop Lehman’s attempt to assume and assign an interest rate swap under which Lehman is currently owed (after netting) more than $1.1 million. The swap was one of several the Board entered into in connection with a debt offering, and was to have run until March 2034, with a declining notional amount after 2017. As interest rates have fallen since the swap was signed, the swap has become valuable to Lehman. If interest rates had risen, Lehman would have been subsidizing the Board's debt payments.

The Board seeks three forms of declaratory relief:  a judgment that several events of default under the swap are “enforceable,” a judgment that a “credit support” default can’t be cured, and a judgment that the Board is not obligated to pay the $1.1 million to Lehman.

The first claim is a bit puzzling, as I don’t know what it means to say that a default is “enforceable.”  Plainly there have been at least three “Events of Default” as defined in the ISDA 1992 Master Agreement that was used in this transaction. There also appears to have been a “Termination Event,” although it is not mentioned in the Board’s complaint – the parties included a termination event based on a downgrade in Lehman’s credit rating.

As for Events of Default, first, it was an Event of Default when Lehman Holdings filed its chapter 11 petition, as Holdings was a “Credit Support Provider” under the swap. Second, it was an Event of Default when Lehman Brothers Special Financing Inc. (“LBSF”), the actual counterparty on the swap with the Board, filed its own petition a few weeks latter. And finally, LBSF also created another Event of Default when it stopped making payments on the swap just before, and after its bankruptcy filing.

Under the terms of the swap, LBSF was to pay monthly floating rate payments, while the Board made semi-annual fixed rate payments. LBSF stopped paying on October 1, 2008, two days before it filed its petition, and the Board skipped its March 2009 payment, as it was allowed to do following LBSF's failure to pay. The $1.1 million that Lehman seeks from the Board is the amount the Board would have paid in March, less the payments LBSF should have made.

Thing is, under the Master Agreement, an Event of Default does not immediately give rise to an ability to terminate the swap – unless the parties elect “Automatic Early Termination,” which they didn’t here. Termination only follows the delivery of a notice of default, which does not seem to have happened, as there is no mention of it in the complaint. That is, the defaults gave the Board an option to terminate, but they do not seem to have exercised it and the swap thus remains "unterminated."

Indeed, in this particular case the parties had agreed that the non-defaulting party would have two options upon delivery of a notice of default: the normal option, payment of a Settlement Amount, based on the current value of the swap, or forced assignment of the swap by the defaulting party to a credit-worthy swap market maker. The second option is what Lehman is attempting to achieve, albeit under the Bankruptcy Code as the swap documents only give the option to the non-defaulting party.

In short, the documents provide for a procedure upon an Event of Default, but the Board, as non-defaulting party, has declined to use that procedure. Instead, they seek a declaratory judgment that “the Events of Default are material and enforceable against LBSF and permanently excuses the School Board’s obligations to make payments to LBSF in respect of the Swap Agreement.”

The Board’s argument gets too close to the long-rejected notion that breach of a contract somehow vaporizes the contract (see Westbrook, 74 Minn. L. Rev. 227, for more on this). Breach instead triggers a right to damages – but here there doesn’t seem to be any damages and the parties expressly acknowledged that early termination could give rise to a payment to the breaching party if the market value of the swap is in its favor – and the payment expressly includes “Unpaid Amounts,” which are defined to include payments that would have been made but for the occurrence of an Event of Default or Termination Event.

Essentially the Board is trying to develop a form of early termination that is not recognized by the Master Agreement (the "no payment termination").  A fine common law argument, but for the contract itself.

This bears watching. A ruling in favor of the Board would give non-debtor counterparties a huge windfall – essentially an option to ignore bad bets on derivative contracts simply because of a bankruptcy filing. That is an even greater power than the option to end the deal,contained in an ipso facto clause and now clearly enforceable because of the safe harbors.

I’ll address the Board’s two arguments regarding assumption and assignment of the swap in my next post.


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See Section 2(a)(iii) of the ISDA Master. Each party's payment obligations are subject to the condition precedent that the other party is not in default.

The bankruptcy court doesn't seem to think that this provision is enforceable - there was a hearing on a motion involving a counterparty called Metavante - but the Board is not making up a new form of termination.

Section 2(a)(iii) is why I said the Board was within its rights to suspend payments when Lehman stopped paying, but the definition of "Unpaid Amounts" ("the amounts that . . . would have become payable but for Section 2(a)(iii) . . . ") makes it pretty clear that the suspended payments will be taken into account as part of the termination of the swap. The Board seems to want to avoid that by not triggering the termination process provided for in the contract.

And section 560 does not appear to bar the use of section 365 to assume the contract.

I agree that the gist of the Bd of Educ argument seems to be that, in the event of a default, the nonbreaching party's remedy ought to be rescission. That is not only dangerous precedent for contract law in general. It is also a dangerous reading of derivative contracts in general. After all, the point is to price risk. If, on breach, the other party gets to rescind, then the pricing model goes out the window. It would be rather like going to Vegas, putting your money on Red 21, then demanding your money back if the ball lands on Black 17 instead.

It's correct that Unpaid Amounts get taken into account if and when the swap is terminated, but nothing in the contract requires the Non-defaulting Party to terminate.

The debtor's recourse in this situation is to assume and assign the contract (or to choose Automatic Early Termination at the outset). When they assume, they would have to provide adequate assurance of future performance. As far as I know, Lehman has not attempted to do so. Rather, their strategy is to force counterparties to continue making payments as long as the net payment is in Lehman's favor, while retaining the option to reject the contract if the market ever shifts in the counterparty's favor. That turns the swap into an option for Lehman.

Assignment would avoid any windfall to the Board while protecting the Board's right not to make payments to a counterparty that has no intention of ever performing.

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