Friday, February 12, 2010

S&P's On The Impact Of The U.S. Bankruptcy Court Decision On Swap Termination Payments

NEW YORK (Standard & Poor's) Feb. 9, 2010--After reviewing a recent U.S. court decision that casts doubt on the enforceability of payment modification provisions involving U.S. swap counterparties, Standard & Poor's Ratings
Services believes that the ratings impact will likely be limited to certain structured finance transactions. In our view, the ruling will most likely affect structured finance transactions that rely on the upfront payment of collateral and the subordination of termination payments (terminating structures). We are currently reviewing our ratings on these transactions.

On Jan. 25, 2010, Judge James M. Peck of the U.S. Bankruptcy Court for the Southern District of New York ruled on the enforceability of a payment modification provision in a case concerning Lehman Bros. Special Financing Inc. (Lehman) as a swap counterparty. In the issuances from the Dante Finance Public Ltd. Co. (Dante) program, the payment modification provision in the trust deed would subordinate Lehman's otherwise senior claims to payments from trust collateral proceeds whenever a swap termination resulted from a default of Lehman under the swap agreement. Lehman sought a determination that the payment modification provision was unenforceable under U.S. bankruptcy law in an effort to compel the collateral trustee for Dante (BNY Mellon) to dispose of the collateral and distribute the proceeds to Lehman before making any payments to the noteholders.

The court ruled that the payment modification provision in Dante was unenforceable because subordination of the termination payment was triggered, ipso facto, by Lehman's bankruptcy filing or that of its swap guarantor (Lehman Bros. Holdings Inc.; LBHI). The court also held, among other things, that the payment modification provision would not fall under the protections of the safe harbor provisions of the U.S. Bankruptcy Code.

In a Nov. 6, 2009, decision, a U.K. court reached a different conclusion under U.K. law in a parallel case brought by a representative of noteholders to compel BNY Mellon to dispose of the collateral and distribute the proceeds to the noteholders before making any payments to Lehman. The U.K court held that the payment modification provision was triggered by the bankruptcy filing of LBHI, which occurred before Lehman filed for bankruptcy and did not violate the "anti-deprivation" principle of U.K. law. On Feb. 2, 2010, BNY Mellon announced that it will appeal the U.S. Bankruptcy Court's decision.

In our view, the U.S. court's ruling could have the greatest rating implications for existing transactions where arrangers have attempted to mitigate credit default swap counterparty risk by structuring deals to provide for posting collateral, redeeming the notes following counterparty default, and subordinating the termination payments to the counterparty to the noteholders' rights when the counterparty is the defaulting party. Under this approach, the counterparty remains in the transaction and posts additional collateral, even as its rating deteriorates. In these types of transactions, the documents typically provide that, if the counterparty defaults, termination payments would not be owed to the counterparty ahead of noteholders. Most synthetic collateralized debt obligation (SCDO) transactions used this approach to mitigate counterparty risk. Because we believe it is likely that many existing SCDO transactions have not been structured to absorb the potential additional costs of paying termination amounts to defaulting counterparties, absent other relevant considerations, it is possible that we may rate the notes no higher than the rating of the counterparty.

Our current view is that the U.S. Bankruptcy Court's ruling would be generally unlikely to affect our ratings on existing transactions structured with replacement provisions. In those transactions, counterparties agree to provide collateral and replace themselves within specified timeframes when their ratings are no longer viewed as sufficient under our criteria to support the ratings on the notes.

In light of the U.S. Bankruptcy Court decision, we are reviewing existing SCDO transactions (and certain other transactions) to assess, on a case-by-case basis, whether the risk to the special purpose vehicle associated with counterparty default is consistent, pursuant to our criteria, with the current applicable rating level.

Standard & Poor's will continue to monitor developments pertaining to Dante. We also continue to review our counterparty risk methodology.

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