Bankruptcy

Derivatives in Bankruptcy -- Part 2

By Stephen Lubben

In my last post, I used the Chicago Board of Education's suit against Lehman Brothers to explore some of the interesting issues concerning derivative contracts that have been brought forward by Lehman's chapter 11 case. While I expressed some skepticism about the Board's argument that Lehman's defaults would justify nullification of the contract, the Board makes two other arguments that I want to say a few words about and at the very least raise the issue of how derivatives interact with §365 after the enactment of the safe harbor provisions in 2005.

First, note that the safe harbor provisions only prohibit the application of §365(e)(1) -- which invalidates ipso facto clauses -- to derivative contracts, thereby leaving open the possibility that derivative contracts can be subject to the normal rules of assumption, assignment, or rejection if not otherwise terminated under safe harbor provisions like §§362(b)(27), 560, and 561.

But the Board argues that by virtue of §365(b)(1)(A), which was amended in 2005 in a way that suggests that non-monetary defaults are only excusable in the context of real estate leases, Lehman can't cure the default caused by Lehman Holdings' chapter 11 filing. Holdings was a "Credit Support Provider" under the interest rate swap in question, and its chapter 11 petition constituted an Event of Default under the terms of the swap. Moreover, the Board argues that the default is not excused by §365(b)(2) -- which invalidates provisions that trigger defaults based on financial distress -- because (b)(2)(A) is expressly tied to the financial condition of the debtor, whereas the provision in question involves the financial condition of the debtor's parent company.

Sure, but (b)(2)(B) invalidates defaults caused by "the commencement of a case under this title," without any reference to who filed said case. I suggest this presents a real problem for the second count of the complaint.

In the background section of the complaint, the Board further argues that they would not have entered into the swap but for the credit quality of Lehman Holdings -- insert snarky comment about the rating agencies here -- a kind of oblique reference to the policy considerations behind §365(e)(2)(B), which limits the debtor's assumption powers with regard to loan and other "financial accommodation" contracts. Although the Board never cites this provision -- and, to be sure, a complaint is not a brief -- this strikes me as a strong argument. However, it is not necessarily an argument that the bankruptcy court should accept, as it would likely lead to an argument that almost any agreement with an investment bank is "un-assumable."

The Board's third claim in the complaint argues that Lehman's failure to pay during the chapter 11 case excuses the Board's payment of the cure amount (which, as I explained in the prior post, would involve a payment in Lehman's favor). This argument exalts section 2(a)(iii), which clearly allows suspension of payments when the other party is not paying, at the expense of other parts of the Master Agreement, including the definition of "Unpaid Amounts" ("the amounts that . . . would have become payable but for Section 2(a)(iii) . . . ") which is included in the amounts that will be paid upon termination of the swap. See section 6(e)(i)(3) -- which is the method of termination the parties elected for this swap.

Full post as published by Credit Slips on September 08, 2009 (boomark / email).