Posted on FT's Alphaville by
On Monday, FT Alphaville remarked upon a report by Finance Asia on a ruling in a US bankruptcy court that, as we put it, “may turn out to be something of a game-changer” as far as the world of credit derivatives was concerned.
In short, past assumptions regarding counterparties’ ongoing obligations to bankrupt swap partners appeared to have been torn up.
The report (and our coverage of it) was a bit short on detail, but here’s what we’ve learnt since. Take a deep breath…
- The ruling on September 15, by Judge James Peck in Manhattan, centred on a dispute between Lehman Brothers and Metavante Technologies, a specialist provider of banking and payment technology, over an interest rate swap agreement.
- Metavante, relying on section 2(a)(iii) of the supposedly sacrosanct ISDA Master Agreement, had opted to cease making payments to Lehman.
- Section 2(a)(iii) permits the non-defaulting party to a swap contract governed by the Master agreement to suspend performance - in this case, to make payments due - while an event of default was continuing. Metavante argued that Lehman’s Chapter 11 filing constituted an event of default, left it without an effective counterparty, and freed it from any obligation to continuing making payments to Lehman.
- As of May 29, Metavante owed Lehman “approximately $6,640,138 representing net payments for the November 2008 and the February and May 2009 payment dates,” according to court filings. The company also owed default interest on unpaid amounts, the documents said.
- Metavante also argued that, as the non-defaulting party in the agreement, it had the option to wait to terminate the trade until market conditions moved in its favour. Lehman, somewhat unsurprisingly, disagreed with that position. The bank told the court:
In direct contravention of the specific provisions of the Bankruptcy Code, Metavante improperly is attempting to take advantage of the Debtors’ chapter 11 cases and avoid its obligations to make its payments to LBSF. The purported rationale for this failure to make payments is that the commencement of chapter 11 cases by LBSF and LBHI constituted “Events of Default” under the Agreement. The failure to make payments under the Agreement, however, ignores section 365(e)(1) of the Bankruptcy Code, which expressly prevents parties from modifying the rights of a debtor under an executory contract “at any time after the commencement of the case solely because of a provision in such contract . . . that is conditioned on . . . the commencement of a case under this title . . . .
- On September 15, Judge Peck sided with Lehman.
- The ISDA Master Agreement is fundamental to, and provides a template for, the derivatives market. As one experienced industry participant put it: “The Master, after the Bible and the Koran, is probably the most scrutinised document out there.”
- When Judge Peck ruled last week that Metavante would, in fact, have to continue to perform - i.e. make payments to Lehman - unless it terminated the agreement, it “blindsided the market”, the person said. Why? For one thing, nothing like this had ever happened in the US.
- There had been a similar case in Australia in 2003. In “Enron Australia v. TXU Electricity Ltd”, the court - contra Peck - permitted TXU to withhold performance under Section 2(a)(iii) indefinitely. Crucially, the court found that Australia’s bankruptcy laws did not permit it “to deprive the counterparty of its contractual rights, such as the right not to designate an Early Termination Date . . . and the right under section 2(a)(iii) not to make a payment.”
- Still, as far as the logic of the bankruptcy court goes, Peck’s decision was not at all unreasonable. As several senior bankruptcy lawyers consulted by FT Alphaville explained (and per Lehman’s argument quoted above) insolvency law “simply does not tolerate reliance on an ipso facto provision.” That is, section 2(a)(iii) should be considered to apply in every event of default except bankruptcy.
- ISDA, the body that is the de-facto voice of the derivatives industry, has come out on the side of the pragmatic bankruptcy lawyers. As ISDA chief executive officer David Geen told the FT:
We didn’t learn anything in Metavante we didn’t already know.
When you’re entering into these agreements, you have to make a decision regardless of the jurisdiction you deal in whether you are prepared to accept the risks involved
It’s just another reminder that their agreements are always subject to applicable bankruptcy laws…people dealing in the US would have been advised that 2(a)(iii) and the right to terminate is going to be affected by applicable law even if it’s not specified in the agreement
- Of course, the argument that people should have known better is not the same thing as saying people did know better, especially since the only other piece of case law on the matter (in Australia) came to exactly the opposite conclusion as that of Judge Peck.
- At the very least, the decision will make it harder for companies that have open, out-of-the-money trades with the Lehman to keep the contracts open and avoid making payments.
- Of course, the provision applies equally to any in-the-money counterparties. More broadly, the Metavante decision will make it more difficult for any counterparty to rely on 2(a)(iii ) as a walkaway clause.
- Judge Peck’s ruling also affects the safe harbour provision for swaps in the event of a bankruptcy. As Richard Schetman, partner at law firm Cadwalader, Wickersham & Taft commented (our emphasis):
The court is saying that while you don’t have to designate an early termination you then have to perform, and if you do elect to terminate under the safe harbor you have to do so within a reasonable amount of time after the bankruptcy occurs
- And, as Goodwin Proctor pointed out,
[Peck found that ]the safe harbour provisions of the Bankruptcy Code “protect a non-defaulting swap counterparty’s contractual rights solely to liquidate, terminate or accelerate” derivatives transactions upon the bankruptcy of their counterparty, or to “offset or net out any termination values or payment amounts” in connection with such a termination, liquidation or acceleration. By “simply withholding performance,” Metavante was not attempting to take any of these actions and was thus not protected by the Bankruptcy Code safe harbors. Judge Peck then found that the contract between Metavante and Lehman was a “garden variety executory contract,” subject to the general executory contract principles of the Bankruptcy Code.
- It is worth noting that until Metavante, there was no guidance on just what constitutes a “reasonable amount of time” regarding termination’ in either the ISDA Master or under existing US bankruptcy laws. The Metavante decision, which in effect said “you have a right to terminate but you can’t sit on it forever”, seemed to define “forever” as about a year.
As Clifford Chance observed in a client memo:
Although the safe harbor provisions of the Bankruptcy Code otherwise would have permitted Metavante to terminate the swap agreement on account of Lehman’s bankruptcy, the Court found that Metavante had waived its right to terminate the swap by waiting a year to do so. The Metavante swap agreement included the standard ISDA Master Agreement language that permits termination following a counterparty’s bankruptcy. The Court cited an earlier case for the view that a counterparty’s actions under the special swap protections must be made “fairly contemporaneously with the bankruptcy filing.” The Court observed that, although Metavante may not have had the obligation to terminate immediately upon filing, its failure to do so after a year constituted a waiver (notwithstanding contractual provisions in the ISDA Master Agreement that a delay in exercising a right does not constitute a waiver).
- The case has also created uncertainty over the critical issue of whether there even exists a window of time after a bankruptcy filing during which a non-defaulting party may withhold payments. Again, from Clifford Chance:
In the absence of such a window, a counterparty would need to decide by its next scheduled payment date whether it wants to terminate or pay. The import of the Metavante decision is that a swap counterparty may not reasonably anticipate a grace period from its performance in accordance with its obligations arising under the ISDA Master Agreement. Like any other “executory contract,” performance remains due on both sides notwithstanding the pendency of the bankruptcy case and until such time, if ever, that the contract has been rejected or otherwise disaffirmed by the debtor.Now, don’t even let us get started on Dante…