For participants in the over-the-counter ("OTC") derivatives markets, perhaps the most significant recent US legal decision interpreting counterparty rights upon a bankruptcy event of default was the September 15, 2009 bench ruling in the US Lehman Brothers chapter 11 bankruptcy cases, In re Lehman Brothers Holdings, Inc., Case No. 08-13555 et seq. (JMP)(jointly administered) ("Bankruptcy Case"). In this decision, the Bankruptcy Court for the Southern District of New York ("Court") found against non-defaulting counterparty Metavante Corporation and for debtors Lehman Brothers Special Financing, Inc. ("LBSF") and its credit support provider Lehman Brothers Holdings Inc.("LBHI") - in a case of first impression pitting the ISDA Master Agreement standard terms against provisions of the US Bankruptcy Code. In short, the Court decision:
- held that the so-called "safe harbor" protections of the US Bankruptcy Code only protect a non-defaulting party's right to liquidate, terminate or accelerate a swap, to offset and to net termination values and payment amounts and to foreclose on collateral, but do not permit the withholding of performance under a swap if the swap is not terminated;
- compelled counterparty Metavante to make all past payments due under certain interest rate swaps governed by an ISDA Master Agreement, together with default interest, as well as future scheduled payments as they came due, despite Metavante's contractual right under section 2(a)(iii) of the ISDA Master Agreement to withhold such payments based upon the ongoing bankruptcy events of default of counterparty LBSF and its credit support provider LBHI; and,
- deemed 11 months after the bankruptcy filing to be too late for Metavante to invoke early termination and instead imposed a sunset on a non-defaulting counterparty's right to early termination upon a bankruptcy event of default despite no such sunset provision in either the derivatives contract or the US Bankruptcy Code itself.
Metavante's appeal of the Court's decision is pending, but the Lehman debtors have proceeded to file numerous similar actions against other counterparties to compel withheld payments, in each case citing to the Metavante decision. This Client Alert summarizes the key issues raised (but not necessarily resolved) by the Metavante decision and similar subsequent disputes now pending before the Court.
The Metavante ISDA Agreement and Debtors' Motion to Compel
In 2007, Metavante and LBSF entered into a fairly standard interest rate swap transaction pursuant to a 1992 ISDA Master Agreement with LBSF, as the floating rate payer, making quarterly payments based on a floating interest rate and Metavante, as the fixed rate payer, making quarterly payments based on a fixed interest rate. LBSF's obligations were guaranteed by LBHI. Pursuant to the terms of the swap, the floating and fixed payments were netted, and the party with a net payment obligation was required to pay the difference to the other party on each scheduled payment date. The ISDA Master Agreement included the standard terms for (a) events of default, including section 5(a)(vii) for the bankruptcy of a counterparty or its credit support provider, (b) the right under section 6(a), but not the obligation, of the non-defaulting party to designate early termination upon the occurrence of an event of default, and (c) the right under section 2(a)(iii) of the ISDA Master Agreement (referred to in this Alert as "section 2(a)(iii)" or simply "2(a)(iii)") to withhold performance upon the occurrence of an event of default that is continuing. The ISDA Master Agreement was governed by NY law and both counterparties were US entities.
LBHI filed for bankruptcy protection under Chapter 11 of the US Bankruptcy Code on September 15, 2008, followed three weeks later by LBSF's bankruptcy filing on October 3, 2008. Under section 5(a)(vii) of the ISDA Master Agreement, each bankruptcy filing was a separate and independent event of default giving rise to (a) Metavante's right to designate an early termination date, and (b) the trigger of the right to withhold performance under section 2(a)(iii) of the ISDA Master Agreement, as long as an event of default was continuing. An early termination of the ISDA Master Agreement by Metavante would have yielded a substantial payment in favor of LBSF. Metavante did not designate an early termination of the ISDA Master Agreement and instead withheld payments that became due under the individual transactions that remained outstanding.
In May 2009, the debtors moved to compel Metavante's performance (payment of all amounts due plus default interest for past due amounts) arguing that the underlying swaps were simply executory contracts that ordinarily could not be terminated or modified under applicable law other than by the debtors. Generally, bankruptcy-based contract terminations are unenforceable; non-debtor swap counterparties, however, may enforce bankruptcy termination as a contractual right pursuant to the specific "safe harbor" provisions of the US Bankruptcy Code. While conceding that these special provisions of the US Bankruptcy Code expressly allow the non-defaulting swap counterparties their contractual rights upon a bankruptcy filing to terminate, accelerate or liquidate their positions in such executory contracts and to net payments, Lehman argued that such rights only adhere upon termination. Lehman further argued Metavante's reliance on ISDA section 2(a)(iii) as an alternative to prompt termination of the contract was contrary to legislative intent to permit markets to continue functioning in the direct aftermath of a major player's collapse. Finally, Lehman challenged Metavante's reliance upon section 2(a)(iii), decrying it an unenforceable ipso facto clause in violation of US Bankruptcy Code section 365(e) (in essence an impermissible bankruptcy penalty). Lehman essentially argued that by invoking section 2(a)(iii), Metavante effectively modified the parties' contract rights by permitting indefinite suspension of performance obligations only because of the financial conditions of the debtors and commencement of the bankruptcy cases.
Metavante countered by citing to: (a) the ISDA Master Agreement which clearly provided that the non-defaulting party had the right, but not the obligation, to terminate all outstanding transactions, and that such right had no time limit or market-related conditions; (b) section 2(a)(iii) which expressly permitted the non-defaulting party to suspend its performance while an event of default was continuing, again with no contractual time limit and no exception for a bankruptcy event of default; and, (c) the US Bankruptcy Code itself which expressly excepts from the ipso facto clause prohibition a derivative counterparty's broad exercise of its contractual right to terminate, set-off and net its positions under a swap or master netting agreement, and does so without imposing any statutory time limit. Metavante did not dispute that an early termination of the ISDA Master Agreement would result in a multi-million dollar payment to Lehman, or that the scheduled payments otherwise due were substantially net in favor of Lehman.
The Court's Decision
On September 15, 2009, after Metavante and Lehman informed the Court that they had been unable to settle their dispute since the prior court hearing 2 months earlier, the Court appeared visibly displeased with Metavante's lack of settlement efforts and denied Metavante's request for a further adjournment. Instead, the Court ruled from the bench in favor of Lehman, expressly limiting the enforceability of section 2(a)(iii) of the ISDA Master Agreement and the scope of the US Bankruptcy Code protections for non-defaulting parties to derivatives contracts. In its ruling, the Court found that:
- each of LBHI's and LBSF's bankruptcy filings did constitute separate events of default under the ISDA Master Agreement and triggered Metavante's right to terminate the transaction;
- safe harbor provisions of the US Bankruptcy Code apply only to the specific delineated contract rights to "protect a non-defaulting swap counterparty's contractual rights solely to liquidate, terminate or accelerate" derivatives contracts upon the bankruptcy of a counterparty, or to "offset or net out any termination values or payment amounts" in connection with such a termination, liquidation or acceleration;
- the exceptions to the unenforceability of an ipso facto clause -- for executory contracts that are swaps -- do not extend to the contractual right to withhold performance under section 2(a)(iii) where such indefinite delay of performance is triggered because of the financial condition of the debtors; suspension of payments (as opposed to early termination) thus amounts to a prohibited modification of the parties' rights and obligations under the contract;
- by failing to terminate, liquidate or accelerate the swap, Metavante had no available rights or protections under the safe harbor provisions and the ISDA Master Agreement thus remained a "garden variety executory contract" subject to the general provisions for executory contracts under the US Bankruptcy Code; and
- despite no contractual or statutory time limit on the right to terminate derivative transactions because of a bankruptcy default, by failing to terminate the transactions more than 11 months after the debtors' bankruptcy filings Metavante's "window to act promptly under the safe harbor provisions has passed" and its failure to terminate by that time resulted in a waiver of its rights to do so.
In addition, the Court noted that the transactions at issue in Metavante were simple, straightforward interest rate swaps. Scheduled payments and early termination payments were therefore easy to calculate and the amounts of the principal payment obligations themselves were not in dispute; payments were overwhelmingly in favor of Lehman at payment dates subsequent to the commencement of the Bankruptcy Case, and based upon the one-sided movement in the markets were expected to remain so for the foreseeable future; the swaps were structured to permit netting of obligations at each scheduled payment date such that the party with net payment obligations need not await a performance trigger of the other party's payment; and Lehman had more than adequate resources to meet its floating rate payment obligation in the event it determined to assume the derivatives contract going forward.
Not only did the Court then compel Metavante to make all past due payments, but it also required that such payments be made with interest at the contractual default rate (and despite the absence of a fixed default rate in the transaction documents). The Court denied Metavante's motion for reargument or modification of the decision; further determinations, perhaps including the applicable default interest rate, await resolution of Metavante's appeal.
Open Issues After Metavante
The Metavante decision leaves a number of unanswered questions about derivative counterparties' rights as to the timing to effectuate early termination and the rights to suspend performance of payment obligations in the interim.
Is there a distinction between continuing default of guarantor vs debtor/obligor? The decision fails to address the fact that Metavante's right to suspend payments may be viewed as triggered as soon as LBHI filed for bankruptcy but before LBSF filed. Notably, while the Court agreed with Metavante that each debtor's respective bankruptcy filing was an independent event of default, the decision effectively conflates the two into a single of event of default that renders Metavante's reaction a violation of the prohibition against ipso facto clauses. The significance of the gap in time is that to the extent 2(a)(iii) may be viewed as modifying contractual rights of the parties, Metavante's contractual rights arguably were modified before the bankruptcy of its actual debtor counterparty, LBSF, and not because of the LBSF bankruptcy but in response to the guarantor's default. Therefore, the suspension of payments falls altogether outside the prohibitions against ipso facto clauses and the safe harbor provisions of the US Bankruptcy Code. In other words, section 365(e) of the US Bankruptcy Code, which prohibits contract parties from enforcing an event of default conditioned solely upon the financial condition or bankruptcy of the debtor, would not be applicable to the bankruptcy event of default of the guarantor. The Metavante decision also fails to address whether section 2(a)(iii) would be enforceable as written against the debtors as a result of any non-bankruptcy event of default.
How long is too long to wait? Further, while the Court's decision found that Metavante had waived the right to terminate its transactions 11 months after the occurrence of the bankruptcy events of default, the Court failed to clarify when such waiver had taken place or become effective, and the factors to be considered in determining how long is too long to wait. For example, a delay in timing of a decision to terminate swap transactions may include factors not present or addressed in Metavante, such as: the complexity of the transactions that must be unwound and the challenges in obtaining adequate replacement trades (especially in a market flooded as a result of a major institution's insolvency); the role of swaps and impact of terminations on an entity's overall risk management system; the relative ability to be unhedged for any period of time, and the corresponding need to restructure related or underlying transactions; and the paucity of qualified counterparties remaining in the marketplace.
Impact of legislative intent? Unhelpful to Metavante's position was its insistence that the rights to terminate and/or suspend performance were not only open-ended but could in fact be timed materially to better its position by riding the markets. While the US Bankruptcy Code is silent on the timing of and policy beneath the safe harbor protections for swap counterparties, the legislative history makes clear the underlying strong public policy to protect American financial markets and participants from systemic risks and effects of bankruptcy of major financial institutions, and to do so by permitting the prompt exercise of specific rights not afforded to general contract parties. Query whether a delay in termination would be better tolerated by the Court if caused by the volume and complexity of transactions covered by an ISDA Master Agreement, the challenges in obtaining replacement trades from qualified counterparties, and the issues associated with restructuring an entire portfolio or risk management program in the wake of a counterparty bankruptcy.
Do more complex transactions and circumstances change the outcome? During the Metavante arguments and on several occasions since the ruling as it has presided over related matters, the Court has suggested that each set of facts presented would require its own review, suggesting perhaps more nuanced decisions in the future. Left open is the possibility of further interpretations of the applicable US Bankruptcy Code provisions depending on numerous factors, such as the complexity of the underlying transactions, specifically negotiated provisions for timing and netting of periodic payment obligations, the relative size and sophistication of the counterparties, the impact on periodic payment obligations of more frequent swings in the market values of the underlying trades, and potential conflicts of law where the interpretation of the derivatives contracts is governed by non-US law.
In the course of the Bankruptcy Case, the Lehman debtors initially sought and obtained the right to assign open derivatives contracts without the consent of their counterparties or in the alternative to terminate at any time through consensual settlement. The debtors have since earlier this year refocused energies on compelling counterparty performance for scheduled payments under ongoing contracts, relying upon the Metavante decision. Since the Metavante decision, numerous demands have been sent to counterparties that Lehman has determined owe payments under open derivatives contracts. Approximately a half dozen disputes over similarly withheld payments have been presented to the Court since the Metavante decision, including:
- LBSF and LBHI v. AIG CDS - Lehman's motion to compel performance, notable for: the complexity of interconnected credit default swaps where both parties are purchasers and sellers of protection with respect to multiple reference entities; the nature and timing of events of default by Lehman, including the failure to make premium payments; the timing and amount of periodic payments and dispute over the application of payment netting provisions; and the non-defaulting party's right to adequate assurance of Lehman's future performance;
- The Board of Education of the City of Chicago v. LBSF and LBHI - Declaratory judgment complaint by City of Chicago in connection with its interest rate swap with LBSF, for which LBHI was the guarantor; like Metavante, the City of Chicago has not made payments otherwise required to be made by it under its swap contract relying instead on section 2(a)(iii); unlike Metavante, the City of Chicago expressly argues that the primary event of default upon which it is relying is the pre-petition event of default caused by the failure of LBHI as credit support provider when it filed for bankruptcy protection (thereby creating a credit support event of default), rendering the ipso facto clause prohibition inapplicable to the contract with Lehman because the relevant event of default relates to the financial condition of the guarantor, LBHI and not the debtor LBSF.
- Lehman Brothers Commercial Corporation v. Norton Gold Fields Ltd. - Lehman's motion to compel payments by Australian counterparty due pursuant to a non-terminated gold price swap agreement under the 2002 version of the ISDA Master Agreement, this dispute is notable as the first such disputed transaction governed by English law; further, in addition to relying upon 2(a)(iii) to excuse its settlement payments, Norton argues that LBCC has failed to issue any additional confirmations since September 12, 2008 and, although the confirmations at issue indicate that transactions are cash-settled, Norton contends that LBCC repudiated the agreement (a separate event of default) by failing to make "gold pre-deliveries for settlement"; in response, Lehman relies heavily on Metavante and the relief requested includes enforcement of the automatic stay.
Hearings on each of these matters have been adjourned to Mid-December 2009 or later, with all parties strongly encouraged by the Court to explore settlement in the intervening period.
Until the Lehman cases, few courts around the globe have had occasion to interpret the scope and duration of a non-defaulting counterparty's right to withhold payment upon a bankruptcy event of default and pending its determination of whether or not to invoke early termination. The most oft-cited case is the 2003 Australia decision, Enron Australia v. TXU Electricity Ltd., in which the New South Wales Supreme Court concluded in favor of the enforceability of 2(a)(iii) in the context of an Australian insolvency procedure. Of course, the Australian court was not applying US law (that particular ISDA was governed by English law) and did not have to reconcile the unforceability of the ipso facto clause under the US Bankruptcy Code with the US Bankruptcy Code's safe harbor provisions. Given the sheer volume of derivatives contracts before the Court (debtors were parties to over 1 million on September 15, 2008), the Lehman Bankruptcy Case will undoubtedly continue to provide opportunities for the Court and the appellate courts to further refine "Metavante" rulings, and the Court may indeed modify its position to some degree depending upon the specific facts and circumstance presented in disputes drawing upon the Metavante decision. We are monitoring closely for such developments.
We can expect, however, that the Court will hold fast to its own basic determination that:
- the safe harbors are specific and limited in scope and relate to terminated transactions and settlement payments;
- the rights to withhold periodic scheduled payments due the debtors under derivatives contract section 2(a)(iii) are improper under US bankruptcy law when triggered by a bankruptcy event of default, and
- the right to terminate early must be exercised promptly or be lost.
As recently as a hearing on November 19, 2009, the Court reiterated that Metavante is for now the rule of the case and "applies to every case that falls within those facts until some other court says otherwise." In addition, the Court noted during that same hearing that ISDA has published a memorandum (dated September 30, 2009) in which it found the Metavante decision consistent with the structure of the ISDA Master Agreement and the safe harbors, and maintained that the ISDA Master Agreement remains enforceable under US law as written, but is subject to the US Bankruptcy Code. It may be too early to contemplate published changes to the ISDA Master Agreement addressing sunset limitations for early terminations and/or the limits of 2(a)(iii) under US law, but it is not too early for counterparties to consider such modifications to negotiated agreements and to act quickly upon an event of default.