U.S. District Court Affirms Lehman Ruling Raising Concern on Cross-Affiliate Netting

A recent opinion by the U.S. District Court for the Southern District of New York affirms a 2010 ruling by the Lehman Brothers bankruptcy court, which rendered certain netting and setoff provisions unenforceable in bankruptcy. The core holding – that a counterparty cannot offset pre-petition and post-petition amounts – should come as no surprise to market participants. In reaching that result, however, both courts opined that parties seeking to exercise setoff rights under the Bankruptcy Code’s safe harbor statutes remain subject to the more restrictive mutuality requirements of section 553 of the Bankruptcy Code. That ruling likely will continue to cause some significant changes in the risk management practices of traders.

Swedbank was one of Lehman’s depository banks. As such, Lehman deposited money with Swedbank, both before and after filing its bankruptcy petition. In the latter category, Lehman deposited approximately $11.7 million after September 15, 2008, when Lehman Brothers Holdings Inc. (LBHI) filed its voluntary petition. After the bankruptcy filing, Swedbank notified Lehman that it was placing an administrative freeze on the relevant accounts for purposes of exercising setoff rights.

Swedbank’s receivables arose out of the termination amounts owed under a series of ISDA Master Agreements. Swedbank entered into five ISDA Master Agreements (the Agreements) with Lehman entities, one of which was LBHI. LBHI’s bankruptcy filing triggered an Automatic Early Termination in three of the Agreements. Because LBHI guaranteed the payment obligations of the other Lehman entities, Swedbank asserted that it was owed a net termination payment of approximately SEK 119 million. (Using a present-day conversion rate, Swedbank asserted that it was owed approximately $17.9 million in termination payments.) Swedbank also held a promissory note from LBHI in the amount of approximately $18 million.

Lehman responded to the administrative freeze by asking the court to enforce the automatic stay and by demanding payment of its post-petition deposits. Lehman disputed Swedbank’s setoff rights – initially, with respect to the purported right to offset post-petition amounts due Lehman against pre-petition amounts due Swedbank. As a result, Lehman alleged that the administrative freeze constituted a violation of the automatic stay.