Judge James M. Peck issued an important opinion in the Lehman Brothers bankruptcy late last month. The opinion protects a non-debtor counterparty's right to rely on a contractually agreed methodology for damages calculations upon the liquidation of a safe harbored swap agreement—even if the debtor's bankruptcy triggers the provision. Because Judge Peck issued the opinion shortly before the holidays, the opinion has received scant attention. However, it preserves important safe harbored rights. In the opinion, Judge Peck attempts to distinguish his earlier rulings in the Lehman Brothers bankruptcy where the Court did not permit counterparties to enforce certain contractual rights triggered by the bankruptcy. Mich. State Hous. Dev. Auth. v. Lehman Bros. Derivative Prods. Inc. (In re Lehman Bros. Holdings, Inc.), Adv. No. 09-01728 (JMP), 2013 WL 6671630 (Bankr. S.D.N.Y. Dec. 19, 2013).
The dispute centered on a swap between Lehman Brothers Derivative Products Inc. ("LBDP") and the Michigan State Housing Development Association ("MSHDA"). The swap agreement stated explicitly that a termination as a result of bankruptcy would alter the methodology by which the non-defaulting party calculated damages owed at termination.
As originally drafted, instead of the standard "Market Quotation" methodology, upon a bankruptcy, the non-debtor counterparty would calculate damages using a non-standard "Mid-Market" methodology. This Mid-Market methodology was determined based on "Market Rates and Volatilities and by polling" a group of swap dealers.
Immediately after Lehman Brothers filed for bankruptcy in September of 2008, LBDP and MSHDA entered into an assignment agreement by which LBDP assigned the swap to a non-debtor affiliate, Lehman Brothers Special Financing Inc. ("LBSF") In the assignment agreement, LBSF and MSHDA agreed that termination of the swap due to a LBSF bankruptcy (or payment failure) would trigger the calculation of damages by the Market Quotation methodology. In other circumstances, the Mid-Market methodology would be used.
LBSF filed for bankruptcy in early October 2008, and on November 5, 2008, MSHDA sent a letter to LBSF designating an early termination date. MSHDA calculated that it owed LBSF $36 million in damages under the Market Quotation methodology agreed to in the assignment agreement. LBSF subsequently alleged that had MSHDA used the Mid-Market method, damages would have instead totaled $59 million.
LBSF Argues That Damages Should Be Calculated Using Only Mid-Market Method
LBSF argued that the provision calling for the use of the Market Quotation methodology to value the terminated derivative, rather than the Mid-Market methodology, constituted an impermissible ipso facto clause because LBSF's bankruptcy filing triggered the selection of the methodology. MSHDA replied that although the damages provision constitutes an ipso facto clause, section 560 of the Bankruptcy Code safe harbors the provision and permits the change in methodology.
Section 362 of the Bankruptcy Code protects debtors through an automatic stay of any potentially negative actions non-debtors can take such as litigation, enforcement of remedies and termination of agreements during the pendency of a bankruptcy. Section 560 of the Bankruptcy Code provides a "safe harbor" from the stay, stating:
The exercise of any contractual right of any swap participant . . . to cause the liquidation, termination or acceleration of one or more swap agreements because of a condition [triggered by the bankruptcy or insolvency of the debtor] . . . shall not be stayed, avoided or otherwise limited by operation of any provision of this title.
In essence, section 560 of the Bankruptcy Code permits non-debtors to terminate, liquidate or accelerate swap agreements following a bankruptcy filing by the counterparty despite the automatic stay's statutory restriction on such actions.
The Court concluded that section 560 applied to the swap itself and that section 560 permitted MSHDA to terminate the swap on LBSF's bankruptcy. The key dispute focused on whether MSHDA could apply the Market Quotation methodology on account of LBSF's bankruptcy filing or whether the automatic stay required the use of the Mid-Market methodology. The Court held, inter alia, that "[r]eferring to the ordinary meaning of 'liquidation' leads to the conclusion that the right to cause the liquidation of a swap agreement must mean the right to determine the exact amount due and payable under the swap agreement." The Court stated:
Liquidation and the methodology for carrying out the liquidation are linked concepts; to liquidate is to obtain values prescribed by contract. Using the Market Quotation method to calculate the Settlement Amount is a necessary part of the exercise by MSHDA of its 'contractal right' to 'cause the liquidation' of the swap agreement with LBSF.
LBSF urged the court to distinguish between the termination and the methodology for determining damages. The Court rejected this argument stating that LBSF failed to give weight to the phrase "'the exercise of any contractual right' which connects with the phrase 'to cause the liquidation, termination or acceleration' in section 560. Read together, the act of liquidation, termination or acceleration must be performed in accordance with a contractual provision in the swap agreement." Here, the swap agreement detailed the methodology, and the Court found that the safe harbor protects the counterparty's remedies. The Court further stated that LBSF's distinction lacked logic as "[t]he liquidation method, regardless of amounts realized, is fully 'baked' into the very concept of what it means to liquidate."
Drawing Distinctions With The Court's "Flip Clause" Rulings
The Court attempted to draw distinctions between this case and its prior rulings. LBSF relied on "the proposition that non-enumerated rights are merely ancillary to the safe harbored rights to liquidate, terminate and accelerate" and cited to two prior Lehman rulings by Judge Peck—as well as a similar ruling in the Calpine bankruptcy.
In one case (BNY Trustee), the Court had held that a "flip clause," which subordinated Lehman's rights to payment upon Lehman's default, constituted an unenforceable ipso facto clause. The Court had held that the flip clause arose out of a supplemental agreement and fell outside the safe harbor because it did not deal directly with liquidation, termination or acceleration.
Judge Peck attempted to distinguish the instant case from the controversial "flip clause" ruling stating:
The Liquidation Paragraph of the Assignment Agreement is part of the swap agreement at issue . . . . More importantly, the Liquidation Paragraph, unlike the flip clause in BNY Trustee, deals directly with a safe harbored right – the liquidation of swap agreements. The very act of liquidating and the method for doing so are tightly intertwined to the point that liquidation without a defining methodology is impossible to perform. Simply put, to liquidate is to calculate the Settlement Amount under the terms of the swap agreement.
In Ballyrock, the Court held that section 560 did not safe harbor a provision subordinating Lehman's right to payment. Here, the Court noted that Ballyrock "deals with a provision altering priority of payment and not a provision strictly dealing with liquidation, termination or acceleration."
Finally, the Court compared this case with the Calpine ruling, which dealt with similar safe harbors for forward contracts and held that a clause requiring a defaulting party to provide a written explanation for disputing the non-defaulting party's calculation was not safe harbored. The Calpine court had held that such provisions were "incidental or ancillary" to safe harbored rights. The Court held that here the calculation of damages is not ancillary at all but "so closely connected" to liquidation "that they flow together and become virtually inseparable."
Guidance For Counterparties
Following Judge Peck's rulings in BNY Trustee and Ballyrock, financial markets expressed concerns about courts (most notably the Lehman court) taking a narrow view of the safe harbors, a view that may limit substantially potential options for non-debtor counterparties to safe harbored contracts. Here, Lehman, perhaps emboldened by Judge Peck's prior decisions, sought to narrow the breadth of the safe harbors even further, down to the mere act of terminating the swap. This would deprive counterparties of many contractual rights in the case of a bankruptcy. Judge Peck disagreed, relying on the plain language of section 560, providing some measure of comfort to financial participants in future bankruptcies that courts will apply the plain language of the Bankruptcy Code and preserve relevant counterparty contractual rights triggered by a bankruptcy.
The rulings create uncertainty. It is difficult for a counterparty to know for certain whether a contractual right is "intertwined" with the safe harbored right to terminate, liquidate or accelerate, and is thus protected.
Judge Peck has announced his retirement from the bench. Effective January 30, 2014, Judge Shelley Chapman will handle the Lehman case. Judge Chapman may face the opportunity to clarify these seemingly inconsistent cases and perhaps even have the opportunity to revisit provisions similar to those in BNY Trustee and Ballyrock.