When Lehman Brothers Holdings, Inc. filed for bankruptcy protection on September 15, 2008, Lehman (directly and through its subsidiaries and affiliates) was party to more than 900,000 derivative contracts. Termination of these contracts may require Lehman or its counterparties to make lump-sum termination payments to the other. As Lehman accelerates its efforts to liquidate and monetize as many of these contracts as possible, the first handful of swap-related cases have made their way onto the bankruptcy court docket, which has now become a forum to test the scope and limits of many of the “safe harbor” provisions afforded to swaps, derivatives and other financial contracts under the Bankruptcy Code. Never have so many contracts come under such intense legal scrutiny for the first time, at one time, in the same court.
A number of counterparties to Lehman have commenced adversary proceedings seeking to adjudicate their rights under these agreements, and Lehman has filed a number of motions to collect unpaid amounts it believes are due under these agreements. On September 17, in one such closely watched matter, U.S. Bankruptcy Judge James Peck ordered Metavante Corporation (“Metavante”), a counterparty to Lehman Brothers Special Financing (“LBSF”) in an interest rate swap transaction in which Lehman Brothers Holdings, Inc. (“LBHI”) is the credit support provider, to perform its obligations to pay quarterly fixed amounts owing under the transaction, notwithstanding the bankruptcies of LBSF and its parent. Judge Peck concluded that Metavante could not rely solely on the filing of the Lehman bankruptcy cases to refuse to make payment to Lehman while also not terminating the agreement. More specifically, Judge Peck found that:
- the swap agreement is “in fact, a garden variety executory contract, one for which there remains something still to be done on both sides,” and as such is “enforceable by a debtor against the counterparty;”
- the safe harbor provisions available to swap counterparties under Sections 560 and 561 of the Bankruptcy Code are limited to the counterparties’ right (i) to liquidate, terminate or accelerate its contracts or (ii) to net out its positions; and
- Metavante’s reliance on the standard condition precedent provision of Section 2(a)(iii) of the ISDA Master Agreement to excuse its payment indefinitely due to Lehman’s bankruptcy was counter to Congress’s intent to allow for “prompt closing out” and “immediate termination for default.”
Ultimately, Judge Peck stated that, by 11 months after the commencement of the case, the failure to exercise the right to terminate the swap “constitutes a waiver of that right.” Under his interpretation, counterparties risk waiving their rights to terminate their contracts if they fail to exercise their rights “fairly contemporaneously with the bankruptcy filing.” As this is the first time the issue has been addressed by a U.S. court, the ruling may have widespread ramifications not only for other outstanding Lehman transactions but for the rights of all parties to derivatives transactions prospectively.
Who is “in the money” and who is “out of the money”?
As noted earlier, the timely settlement and liquidation of outstanding derivatives transactions constitute one of the primary objectives of the Lehman bankruptcy estates. By Lehman’s own count, as of June 2009, there were still hundreds of outstanding swaps and other derivatives contracts in which Lehman was “in the money” (i.e., it would be owed a payment upon early termination rather than being required to make one). The “out of the money” counterparties face difficult decisions as a result of the bankruptcy cases. Under the terms of the ISDA Master Agreement1 under which the vast majority of these transactions are documented, the counterparty, as the non-defaulting party, has the right (but not the obligation) to terminate a transaction early or to let it continue. A transaction that is out of the money for a counterparty today may be in the money tomorrow, or at least at sometime prior to its scheduled termination date. Accordingly, the dilemma for these counterparties has been whether or not to continue to perform on these contracts, making payments to Lehman as and when required, in the hope that Lehman might be able to satisfy its obligations at such future time that the markets would move in the counterparties’ favor. With Lehman in Chapter 11, many counterparties may have concluded that Lehman was unlikely to ever be in a position to perform and therefore elected (i) not to terminate their transactions, but also (ii) to withhold any required periodic payments to Lehman in reliance on Section 2(a)(iii) of the Master Agreement. Section 2(a)(iii) provides that the obligation of a party to perform under a transaction is subject to the condition precedent that “no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing.”
Whether, and for how long, a non-defaulting party may exercise these “wait and see” rights is a question that had not been addressed by a U.S. court2 before the Lehman bankruptcy cases, but was among the issues that Judge Peck considered in Metavante.
The Metavante Decision
In November 2007, Metavante entered into an amortizing interest rate swap transaction with LBSF with a notional amount of $600 million under which LBSF, as floating amount payer, agreed to make quarterly payments based on a floating interest rate. Metavante, as the fixed amount payer, agreed to make payments based on a fixed interest rate. Under the transaction, the swapped payments were netted, as is customary, and only the party with a net payment obligation was required to pay the other party on each payment date. The transaction was documented in a 1992 ISDA Master Agreement and customary trade confirmation. LBSF’s obligations were unconditionally guaranteed by LBHI.
On September 15, 2008, LBHI filed for bankruptcy under Chapter 11 of the Bankruptcy Code. Shortly thereafter, on October 3, 2008, LBSF commenced its own Chapter 11 bankruptcy case. Under Section 5(a)(vii) of the Master Agreement, the bankruptcy filings by LBHI and LBSF each constituted a separate event of default by Lehman, each of which entitled Metavante, as the non-defaulting party, to designate an early termination date for the transaction if it so chose. Upon early termination, the Master Agreement generally provides for the transaction to be valued in light of current market rates and otherwise in accordance with certain payment measures and methods specified in the contract. The party determined to be out of the money based on those calculations must make a termination payment to the other party, regardless of which is the defaulting party. Based on Lehman’s and Metavante’s filings in the proceeding, upon an early termination of the swap, Metavante would likely have been obligated to make a significant lump-sum payment to LBSF.
In reliance on the “wait and see” provision of Section 2(a)(iii) of the Master Agreement, Metavante chose to neither terminate nor perform. Based on Lehman’s and Metavante’s filings in the proceeding, Metavante owed periodic net payments to LBSF under the swap transaction but Metavante had not made any of these payments since the Lehman bankruptcy filings.
In May 2009, Lehman filed a motion to compel performance of Metavante’s obligations, asserting that the swap was an executory contract and arguing for a “straightforward application” of Section 365 of the Bankruptcy Code. Specifically, Section 365(e)(1) of the Bankruptcy Code prevents parties from modifying rights of a debtor under an executory contract “at any time after commencement of the case solely because of a provision in such contract . . . that is conditioned on . . . the commencement of a case under this title . . . .” Lehman argued therefore that Section 2(a)(iii) of the Master Agreement was void and unenforceable as an ipso facto clause because permitting a party to indefinitely delay performance in reliance on that provision effectively modified LBSF’s rights solely as a result of the commencement of the bankruptcy cases.
In its motion, Lehman acknowledged that the Bankruptcy Code provides for a safe harbor that exempts the exercise by a swap participant (or certain other derivative contract counterparties) of “any” contractual right arising under a swap agreement (or other derivative contract) and permits a swap participant, among other things, to “offset or net out any termination value, payment amount, or other transfer obligation” under any related transaction.3 While the scope of the safe harbor is expansive in terms of the types of covered transactions, Lehman argued that the safe harbor itself is limited to exercise of the stated remedies only (i.e., liquidate, terminate, accelerate and offset) and did not [give] license [to] other modifications of the debtor’s rights by counterparties.
Conversely, Metavante argued that the terms of the Master Agreement were clear and unambiguous: the non-defaulting party had the right, but not the obligation, to terminate all outstanding transactions, and Section 2(a)(iii) permitted the non-defaulting party to suspend its performance while an event of default was continuing, with no applicable time limit. In its filings, Metavante declared that the “right to elect to terminate – or not terminate – the swap at any time prior to maturity is an essential and critical right of a non-defaulting party.”4 Metavante further noted that a ruling in favor of Lehman’s motion would deprive it of its rights to net/set-off any damages arising from the termination since the non-defaulting party has the right of set-off only upon its designation of an early termination date on account of the other party’s default.
Judge Peck sided with Lehman. In granting the motion, he concluded that the safe harbor provisions of the Bankruptcy Code “protect a non-defaulting swap counterparty’s contractual rights solely to liquidate, terminate or accelerate” derivatives transactions upon the bankruptcy of their counterparty, or to “offset or net out any termination values or payment amounts” in connection with such a termination, liquidation or acceleration. By “simply withholding performance,” Metavante was not attempting to take any of these actions and was thus not protected by the Bankruptcy Code safe harbors. Judge Peck then found that the contract between Metavante and Lehman was a “garden variety executory contract,” subject to the general executory contract principles of the Bankruptcy Code.
Finally, though the Bankruptcy Code itself is silent as to a time-frame within which a non-defaulting counterparty must act to exercise its termination and other rights contemplated under the safe harbor, Judge Peck held that “Metavante’s window to act promptly under the safe harbor provisions has passed, and while it may not have had the obligation to terminate immediately” upon Lehman’s bankruptcy filing, its failure to exercise its statutory rights at this point in the case had resulted in a waiver of those rights.
There are many other derivative and financial contract transactions either pending before the Lehman bankruptcy court or that have yet to be brought before the court – some similar to Metavante and others with minor or major variations on the facts. For example, on August 27, 2009, the Board of Education of the City of Chicago filed a complaint seeking a declaratory judgment in connection with its own interest rate swap with LBSF, under which LBHI was the guarantor as well. The Board of Education similarly has not made payments otherwise required to be made by it under its swap contract and it too is relying at least in part on the “wait and see” provision of Section 2(a)(iii). In its complaint, the Board of Education adds that the primary event of default upon which it is relying is not the bankruptcy filing by LBSF, its counterparty, but the pre-petition event of default that occurred when LBHI, as guarantor, failed to pay its debts as they became due and filed for bankruptcy protection. The Board of Education is arguing at least initially that Section 365(e) of the Bankruptcy Code, which prohibits contracts from containing an event of default conditioned solely upon the financial condition of the debtor, is inapplicable to its contract with Lehman because the relevant event of default relates to the financial condition of the guarantor, LBHI. Whether the Bankruptcy Court will be more receptive to this argument (which appears to be equally applicable to the facts of Metavante) remains to be seen.
The court’s rulings in Metavante also evoke a number of questions. For example, first, embedded in the decision without significant discussion is the finding that a swap is a “garden variety” executory contract and not a contract for “financial accommodation” that would preclude application of the executory contract principles under Section 365. Second, while the Bankruptcy Court’s ruling indicates that 11 months is long enough to constitute a waiver of a non-defaulting party’s right to terminate outstanding transactions upon the other party’s default, the court did not answer the question as to when such a waiver actually occurred or became effective. Neither the relevant safe harbor provision of the Bankruptcy Code nor Section 365 of the Bankruptcy Code addresses this issue, directly or indirectly. Third, it remains an open question as to whether other events of default or potential events of default (i.e., defaults other than those arising from the filing of a bankruptcy case) would be sufficient to excuse payment in reliance Section 2(a)(iii) of the Master Agreement. Nuances in facts and interpretations may give rise to additional questions, of course, especially as the court continues to address similar cases.The Lehman cases may offer answers to these and other questions for those parties that come before the court with different contractual arrangements. More of these disputes are scheduled to be heard on October 15, 2009. If Lehman or any of its counterparties appeals an adverse ruling, then additional guidance may develop. Finally, market participants will closely observe the results in these cases and perhaps reconsider the Master Agreement forms in light of what has occurred. The sheer quantity and complexity of transactions to which Lehman was a party makes the Lehman bankruptcy cases a testing ground for the treatment of derivative financial contract agreements under the Bankruptcy Code and will certainly impact how these agreements are negotiated long into the future.