Bankruptcy cases are the proving ground for interpreting the boundaries for ISDA safe harbor provisions under the United States Bankruptcy Code. Michigan State Housing Development Authority v. Lehman Brothers Derivative Products Inc., et al., Adversary No. 09-1728 (JMP) in the U.S. Bankruptcy Court for the Southern District of New York, is the latest decision considering the scope of the safe harbor provisions for liquidating, terminating, and accelerating swap agreements. It considered whether the safe harbor provision (that protects a non–defaulting party's right to liquidate) also includes and protects the contracted for procedures on how to execute the liquidation and calculate the amounts due from one counterparty to another.
The disagreement in this case concerned the method to be used in calculating the settlement amount when the non–defaulting party liquidated the swap agreement. The Court considered ipso facto language in the Master Agreement, Schedule, and a later drafted Assignment Agreement (a supplemental agreement that was part of the swap agreement at issue) in reaching its decision. The question came down to whether contract terms calling for certain liquidation procedures that were more favorable to the non–defaulting party should be included in the safe harbor protection for swap agreements in Section 560 of the Bankruptcy Code. The Court determined that the plain meaning of the safe harbor exception for swap transactions protects both the act of liquidating and the contracted for procedure to carry it out. The Court noted that the concept of providing an unlimited right to liquidate a swap agreement would be incomplete if it did not also protect and include the methodology the parties chose to determine the amount payable when liquidating under the swap agreement. This case reminds us that for a provision in an agreement concerning a swap transaction to receive safe harbor protection, the agreement must still be a swap agreement and the provision language must strictly deal with liquidation, termination, or acceleration.
In the following excerpt the Court contrasts its ruling in this case with its prior decision in Lehman Bros. Special Fin. Inc. v. Ballyrock ABS CDO 2007-I Ltd. et al. (In re Lehman Bros. Holdings Inc.), 452 B.R. 31, 40 (Bankr. S.D.N.Y. 2011):
"The Court found [in Ballyrock] that the language of [Bankruptcy Code] Section 560 is expressly limited to the specified rights to cause the liquidation, termination or acceleration of a swap agreement and does not authorize non-default parties to swap agreements to improve their standing in a waterfall and obtain higher priority distributions upon the occurrence of a bankruptcy default….The current dispute [in Michigan State Housing] prompts renewed attention to the language of Section 560 and touches again on an ipso facto provision in a qualified financial contract that is a source of economic harm to the debtor associated with the very act of filing for bankruptcy. Despite the superficial similarity of the issues, the earlier determinations made with respect to impermissible changes to distribution priorities [in Ballyrock] are not controlling. Here the question is more nuanced and closer to the statutory core of Section 560, leading to an examination of whether the methodology for conducting an indisputably exempt liquidation is also exempt. This time the scheme of Section 560 – namely protection of the "safe harbored" right to cause a liquidation – is directly implicated in the analysis."
Take Away - - While ordinary non-punitive liquidation procedures/methodology may very well come within the safe harbor protections of Section 560, that may not be the case for punitive swap liquidation procedures/methodology such as "flip clauses" that provide for the non-defaulting party to improve its level of payment priority because of a counter-party bankruptcy filing.
