Since Lehman Brothers Holdings, Inc. filed for bankruptcy in mid-September, and its primary swap affiliate, Lehman Brothers Special Financing, Inc. followed in October, counterparties with Lehman Brothers swaps have had no clear understanding of what might happen with their interest rate swaps or other derivative products.1 Many of the counterparties continue to be “out of the money”, meaning that they would owe Lehman a payment upon termination of the swap, an event that most seek to avoid for two reasons: (1) the cost of termination often is substantial; and (2) finding a replacement swap on similar terms is very difficult except for the most creditworthy counterparties.2
Out of the money counterparties have received varying advice about how to handle their swaps since the initial filing, ranging from withholding monthly payments due Lehman against an ultimate termination payment to continuing to pay Lehman as if there had not been a bankruptcy. Conversely, in the money counterparties have had to wrestle with what, if any, value their swaps have.
On November 13, 2008, Lehman filed a motion in the United States Bankruptcy Court to establish procedures for: (1) termination of derivative contracts, including interest rate swaps; and (2) assumption and assignment of derivative contracts to third parties. This motion raises significant issues for institutions that have derivative contracts with Lehman, especially those institutions that are currently “out of the money” under those contracts.
As a debtor under the Bankruptcy Code, Lehman has the right to assume and assign most “executory contracts”, including interest rate swaps and other derivative contracts. A debtor that has defaulted under an executory contract must cure that default as a condition to assuming the contract (the amount of the payment required to cure such a default is often referred to as a “Cure Amount”). In turn, in order to assign an executory contract to a third party, the debtor must provide adequate assurance of future performance of the contract by the assignee.
Lehman has asked the bankruptcy court to establish separate sets of procedures for: (1) termination of interest rate swaps and other derivative contracts; and (2) assumption and assignment of those contracts to third parties.
The termination procedures would enable Lehman and its counterparties to terminate derivative contracts and reach agreement on termination payments without court approval, so that Lehman will be able to react quickly to changes in the financial markets. These provisions should not present any substantial problems for counterparties, since by definition the requested procedures contemplate a mutual agreement on the termination terms (and, absent such agreement, a methodology for resolution of disagreements).
The assumption and assignment procedures, however, are more troublesome.
First, once Lehman requests permission to assume and/or assign a derivative contract to a third party, the procedures would give a counterparty only five business days to decide whether to object. In order to decide whether to object, a counterparty will have to determine whether the proposed assignee is satisfactory, whether Lehman has provided adequate assurance of future performance by the proposed assignee, and, in some cases, whether Lehman Brothers has accurately calculated the Cure Amount. While five business days is a short period of time to make these decisions, the bankruptcy court is likely to approve this part of the procedures in order to enable Lehman to respond to changes in interest rates and maximize value for the bankruptcy estate. Accordingly, if the court approves these procedures institutions will have to be prepared to react very quickly to requests by Lehman to assume and assign derivative contracts.
Second, the procedures establish a definition of “adequate assurance of future performance” that is favorable to Lehman Brothers and potentially prejudicial to counterparties. While the procedures preserve the rights of counterparties to object to the identity of a proposed assignee, Lehman will be deemed to have provided adequate assurance of future performance by the assignee if either: (i) the proposed assignee or its credit supporter has a Standard & Poor’s or Fitch credit rating equal to or higher than A- or a Moody’s credit rating equal to or higher than A3, or any equivalent, or (ii) Lehman, after payment of any Cure Amounts, “would no longer have any payment or delivery obligations under the [swap contract] . . . .”
The first of those two alternatives – defined in the filing as a “Qualified Assignee” – sets forth a credit rating threshold that is lower than most counterparties would accept when entering into derivative contracts, and may be lower than the derivative contract’s provisions for assignment to a third party in the event of default. The two major issues are: (1) the Qualified Assignee need only have one of the lowest A category ratings; and (2) most swaps refer only to ratings by S&P or Moody’s, not Fitch.
The second of these two alternatives is troubling, in large part because it is ambiguous. At the very least, this proposal creates the possibility that if the counterparty to a derivative contract is “out of the money”, and has been paid any presently owing Cure Amount, the contract could be assigned without any consideration of the creditworthiness of the assignee, because at the time of the assignment Lehman Brothers “would no longer have any payment or delivery obligations” under that contract.
If accepted by the court, counterparties, especially those with long term swaps, could be obligated with assignees without even one “A” category rating. Although one can argue that performance by any non-bankrupt counterparty is better than the current situation, the concept of adequate assurance of future performance typically employed by bankruptcy courts could be turned on its head by acceptance of this procedure.
Any party wishing to object to the proposed procedures must do so by November 28, 2008. Institutions that have derivative contracts who are troubled by the broad ability to assign may wish to consider objecting to this portion of the motion, rather than leaving any potential objection to the time when the contract is proposed to be assigned and the proposed standard has become final.
[1] Derivative contracts generally are not subject to the automatic stay provisions of the Bankruptcy Code.
[2] Lehman acknowledges in its filing that where a counterparty has continued to perform and has not demanded termination, Lehman may not terminate unless the bankruptcy filing itself caused an automatic termination event.