Bankruptcy

Derivatives in Bankruptcy -- part 3

By Stephen Lubben

In two prior posts earlier this month, I examined the Chicago Board of Education's adversary complaint against Lehman, in which the Board struggles mightily to avoid termination of an interest-rate swap under the procedures set forth in the ISDA Master Agreement, as doing so would result in the Board paying Lehman more than $1 million.  On the other hand, the Board does not seem too keen on Lehman's plan to assume and assign the swap either.

In the prior posts I expressed some skepticism about the Board's arguments, but I wanted to use this final post in the series to suggest another argument that might be made in support of the Board's position.

What if the Board dropped its assertions that Lehman's various breaches somehow terminated the agreement, and instead argued that the Bankruptcy Code provides no basis for the payment of cure amounts by non-debtor parties? After all, §365(b)(1)(A) provides that the trustee -- and thus the DIP -- shall cure any defaults.  In Lehman, the debtor is curing by paying the Board negative $1.1 million. The Board has a legitimate argument that it has no obligation to accept such a "payment."

The Board could then invoke the rule of Enron Australia v TXU Electricity, a 2003 opinion from the Supreme Court of New South Wales, which was subsequently affirmed by that court's Court of Appeal, which I read as standing for the proposition that a non-defaulting party can't be compelled to invoke the Early Termination procedures if they don't want to -- essentially where the Board has been since Lehman defaulted.

In Enron Australia, Enron's local subsidiary attempted to reject ("disaffirm" in Australian) a swap that was in its favor, arguing that the court should then order TXU to pay the termination payment to Enron. TXU had not declared an early termination under section 6(a) of the Master Agreement and instead stopped making further payments, relying on section 2(a)(iii) which provides that the obligation to make a payment under a swap is subject to the condition precedent that no Event of Default has occurred. The court agreed that the debtor could reject the swap, but it declined to order a payment to Enron, holding that doing so would amount to a rewriting of the contract, a step or two beyond straight rejection.

Although the opinion is obviously not binding on the Lehman court, the Board could argue that the same rule should hold in an assumption and assignment case. Lehman can be expected to counter that the Board's refusal to "settle up" the swap impedes its ability to use §365's assignment mechanism, unlike the rejection decision in Enron Australia where the debtor's ability to reject was not impaired, rather the court simply rebuffed the use of rejection to obtain something more than breach -- namely, early recovery on an asset.

Moreover, Lehman can argue that the Enron Australia opinion should be rejected inasmuch as it creates a contractual paradox -- how does a swap end if the only party with the right to terminate it won't exercise that right? -- that destroys value in the debtor's estate. Giving the non-defaulting party an option to "run out the clock" essentially means that this option operates like an ipso facto clause, or a bankruptcy penalty clause, which Congress has generally disfavored, and arguably the existing exceptions should be read narrowly.

There is also a question of where this gets the Board.  If it is simply a matter of not paying the cure payment to Lehman, Lehman might simply extract that value from the assignee of the swap, who could expect to collect it in the form of future performance from the Board. The Board can be expected to argue that even the assignee can't resume normal operations under the swap, but again this leaves the swap in a kind of suspended animation that seems to conflict with the ability to "undo" defaults under the Bankruptcy Code.

In short, I'm conflicted about this argument too, although I think it shows more promise from the perspective of a non-breaching party.

Full post as published by Credit Slips on September 14, 2009 (boomark / email).