Turbulence Continues in 'Safe Harbors '

Lehman Brothers

Lehman Brothers Derivative Products Inc., a subsidiary of Lehman Brothers Holdings, Inc. (LBHI) and the Michigan State Housing Development Authority (MSHDA) entered into an ISDA master agreement and accompanying schedule. The master agreement listed certain events of default and termination events that allowed the non-defaulting party to designate an early termination date for any outstanding transactions and to trigger a calculation of amounts owed using an agreed upon methodology. As originally contemplated, the amounts due were to be calculated by using either the “Market Quotation” or “Second Method.” Market Quotation is the method for calculating the settlement amount on the basis of quotations from reference market-makers. The Second Method simply refers to a process in which the out-of-money party pays the in-the-money party regardless of which party has defaulted.

The schedule accompanying the master agreement also included certain special trigger events that constituted additional termination events, one of which was a bankruptcy filing by LBHI. And, if a trigger event occurred, the methodology by which the non-defaulting party would calculate the amounts owed would change to a “Mid-Market” method. The latter called for the settlement amount to be calculated by using market rates and volatilities and by polling the dealer group as required, to be the mid-market value of the transaction as of the close of business (New York time) on the early termination date.

When LBHI filed for Chapter 11, this constituted a special trigger event. However, rather than terminating the outstanding transactions, LBDP and MSHDA entered into an assignment and amendment agreement with LBSF ' at the time, a non-debtor ' in which all of LBDP's rights and obligations under the master agreement and schedule were assigned to LBSF. The assignment agreement also amended the method used to calculate the settlement amount. The amendment's liquidation provision stated that calculation of the settlement amount would be performed using the Mid-Market method, unless terminations were due to the non-payment or bankruptcy of LBSF, in which case the Market Quotation method would be used.

LBSF subsequently filed for Chapter 11, causing MSDHA to declare an event of default, select an early termination date and to calculate the amount owed to LBSF using the Market Quotation method. According to MSDHA, the amount due was approximately $36 million. However, LBSF took the position that had MSDHA used the Mid-Market method, the amount due would exceed $59 million. Thus, the dispute hinged on the method ' Mid-Market or Market Quotation ' that properly should have been used to calculate the settlement amount.

The Issue

The bankruptcy court framed the question presented in Lehman to be what it really means for a non-defaulting swap counterparty to have the unlimited contractual right to liquidate a swap agreement, and whether that protected right properly extends to the contractually prescribed procedures for calculating amounts due and owing from one counterparty to another. In other words, the question was whether a contractual term calling for certain liquidation procedures in bankruptcy that are more favorable from the point of view of the non-defaulting party should be exempt from the rule that generally outlaws such ipso facto provisions.

The bankruptcy court noted that this question goes to the heart of this safe harbor: If the exercise of a contractual right to cause the liquidation of a swap agreement is protected, are the contractually specified means for conducting that liquidation so connected to the very concept of liquidation that they are also protected?

Lehman argued that the less favorable procedures triggered by a bankruptcy default are ineffective ipso facto alterations of a debtor's rights, and so do not fall within the safe harbor. On the other hand, MSHDA and the International Swaps and Derivatives Association, Inc. (ISDA) (in an amicus brief) argued that the protected right to liquidate cannot be viewed as an isolated right and necessarily includes those contractual provisions that provide needed guidance for liquidating and closing out the swap agreement. This dispute regarding scope was central to the meaning and purpose of this safe harbor.

The Bankruptcy Court's Ruling

The bankruptcy court found that these issues call for consideration of the literal meaning of the word “liquidation” consistent with the purposes that underlie the safe harbor for liquidating swap agreements. The court concluded that the protected right to liquidate must include a way to execute the liquidation in order to infuse the safe harbored right with meaning. The concept of an unlimited right to liquidate a swap agreement is incomplete without reference to the methodology that the parties have chosen in their contract for conducting the liquidation. That common-sense construction of the safe harbor comports with the ordinary and customary meaning of the word “liquidate” (to liquidate is to convert an asset to cash by following a set of prescribed procedures) and allows the parties, without needless delay or uncertainty, to determine the amounts payable to terminate their swap agreement with clarity and finality.

Liquidation

The bankruptcy court noted that the ordinary meaning of “liquidation” leads to the conclusion that the right to cause the liquidation of a swap agreement must mean the right to determine the exact amount due and payable under the swap agreement. The amount can only be fixed by following the liquidation methodology specified in the swap agreement. The bankruptcy court further noted that liquidation and the methodology for carrying out the liquidation are linked concepts: to liquidate is to obtain values prescribed by contract. Using the Market Quotation method to calculate the settlement amount is a necessary part of the exercise by MSHDA of its contractual right to cause the liquidation of the swap agreement with LBSF.

LBSF urged the bankruptcy court to adopt a much narrower reading of Section 560 and drew a distinction between the act of termination, liquidation, or acceleration and the method chosen for calculating a settlement amount. According to LBSF, only the acts are safe harbored and other rights, such as how to calculate the amount due, are ancillary rights and are not protected.

However, the bankruptcy court found that LBSF did not give enough weight to the phrase the exercise of any contractual right which connects with the phrase to cause the liquidation, termination, or acceleration in section 560. Read together, the act of liquidation, termination, or acceleration must be performed in accordance with a contractual provision in the swap agreement. Here, the liquidation provision specifies what that right entails. Unless the act of liquidation is performed in accordance with some agreed method, the right to liquidate is disconnected and loses all practical meaning.

Further, according to the bankruptcy court, LBSF failed to explain why a commercially acceptable method chosen by the parties themselves should not be respected or to demonstrate why it is appropriate to use the alternative Mid-Market method. The methods produce different results, but both methods are contractually approved methods for valuing collateral. The result ' whether it produces more or less value for the debtor ' should not be decisive in considering how to apply the safe harbor. The liquidation method, regardless of amounts realized, is fully baked into the very concept of what it means to liquidate. The very act of liquidating and the method for doing so are tightly intertwined to the point that liquidation without a defining methodology is impossible to perform. Simply put, to liquidate is to calculate the settlement amount under the terms of the swap agreement. These concepts (liquidation and liquidation methodology) are so closely connected to one another that they flow together and become virtually inseparable.

The Bankruptcy Court's Reasoning

The bankruptcy court noted that allowing a non-debtor counterparty to use the contractual method of liquidation promotes the systemic goals of the safe harbor ' to provide stability and certainty to the markets upon the insolvency of a counterparty and to enable the parties themselves to liquidate collateral in a contractually prescribed manner.

The bankruptcy court further noted that the protected right to cause the liquidation of a swap agreement must extend beyond the mere capacity to commence a liquidation in a vacuum, and must embrace those related terms of the swap agreement that explain the liquidation protocol to be followed when one party goes into bankruptcy. These may be ipso facto provisions, but they are exempt by statute and permitted.

The bankruptcy court distinguished its prior rulings where it held that the safe harbor provisions of Section 560 of the Bankruptcy Code do not extend to a bargained-for change in the priority of distributions between LBSF as swap counterparty and certain investors in notes issued by a special purpose vehicle. That dispute dealt with the issue of whether a so-called flip clause triggered by a bankruptcy default is an ineffective ipso facto provision.

In that earlier case the bankruptcy court found that the language of section 560 is expressly limited to the specified rights to cause the liquidation, termination or acceleration of a swap agreement and does not authorize non-defaulting parties to swap agreements to improve their standing in a waterfall and obtain higher priority distributions upon the occurrence of a bankruptcy default. S ee Lehman Bros. Special Fin. Inc. v. BNY Corporate Tr. Servs. Ltd. (In re Lehman Bros. Holdings Inc.), 422 B.R. 407 (Bankr. S.D.N.Y. 2010, a decision that was ratified and followed in Lehman Bros. Special Fin. Inc. v. Ballyrock ABS CDO 2007-1 Ltd. et al. (In re Lehman Bros. Holdings Inc.), 452 B.R. 31 (Bankr. S.D.N.Y. 2011).

The bankruptcy court stated that these earlier rulings were made with respect to impermissible changes to distribution priorities and are not controlling. Instead, the court found that the question presented was more nuanced and closer to the statutory core of section 560, leading to an examination of whether the methodology for conducting an indisputably exempt liquidation is also exempt. This time the scheme of section 560 ' namely protection of the safe harbored right to cause a liquidation ' is directly implicated in the analysis.

According to the bankruptcy court, there is a significant difference between the reordering of priorities within a hierarchy of distributions (an ipso facto contractual term that is not mentioned in Section 560) and selecting which method to use when disposing and valuing collateral in connection with liquidating a terminated swap agreement. The choice of an accepted and contractually specified method to liquidate, even if it produces a less desirable result from the point of view of the debtor, is consistent with full implementation of the exemption that is codified in section 560. The bankruptcy court determined that this provision of the swap agreement is a contractual right to cause the liquidation (i.e., to liquidate), and accordingly is squarely within the safe harbor, not outside of it.

Conclusion

Accordingly, the bankruptcy court held that the alternative approach to liquidation of collateral used by MSHDA is effective even though it is contained in an ipso facto provision because that alternative is protected by the safe harbor of section 560 and, as a consequence, is not subject to the ipso facto limitation contained in section 365(e)(1). The court concluded that when dealing with a swap agreement, the exercise by a swap participant (here, MSHDA) of a contractual right to cause a liquidation of the swap agreement in question is a unified concept because the act of causing a liquidation calls for the collection of market data in a particular manner from specified sources to obtain pricing information. For that reason, the plain meaning of this safe harbor protects both the act of liquidating and the manner for carrying it out. The act of causing liquidation and the methodology converge to the point of being one and the same. Accordingly, the procedures followed by MSHDA in determining the settlement amount were protected by the safe harbor of section 560.

Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC and a member of this publication's Board of Editors. He may be reached at
[email protected].

'

Last month, Part One of this two-part article discussed the prosecution of post-confirmation state law fraudulent transfer claims in the Lyondell case and highlighted conflicting views coming from within the United States Bankruptcy and District Courts for Southern District of New York.

This month, I discuss a recent decision in the Lehman Chapter 11 case, where the bankruptcy court held that the methodology to be used to calculate amounts due in connection with the liquidation of certain swap transactions under Bankruptcy Code section 560 is governed by the contractual terms of the relevant master swap agreement and accompanying schedule and such terms are not invalidated by ipso facto provisions contained in the Bankruptcy Code. See Michigan State Housing Dev. Auth. v. Lehman Bros. Deriv. Prods. Inc. (In re Lehman Bros. Holdings Inc.), No. 08-13555, —B.R. —-, 2013 WL 6671630 (Bankr. S.D.N.Y. Dec. 19, 2013).

This decision represents a broader plain meaning interpretation of the section 560 safe harbor provision for swap agreements, and departs from bankruptcy court's prior much narrower flip-clause rulings. One remaining question that counterparties will face, however, is how to determine whether a contractual right contained in a swap agreement is sufficiently “baked” into the agreement so as to be protected by the section 560 safe harbor.

Lehman Brothers

Lehman Brothers Derivative Products Inc., a subsidiary of Lehman Brothers Holdings, Inc. (LBHI) and the Michigan State Housing Development Authority (MSHDA) entered into an ISDA master agreement and accompanying schedule. The master agreement listed certain events of default and termination events that allowed the non-defaulting party to designate an early termination date for any outstanding transactions and to trigger a calculation of amounts owed using an agreed upon methodology. As originally contemplated, the amounts due were to be calculated by using either the “Market Quotation” or “Second Method.” Market Quotation is the method for calculating the settlement amount on the basis of quotations from reference market-makers. The Second Method simply refers to a process in which the out-of-money party pays the in-the-money party regardless of which party has defaulted.

The schedule accompanying the master agreement also included certain special trigger events that constituted additional termination events, one of which was a bankruptcy filing by LBHI. And, if a trigger event occurred, the methodology by which the non-defaulting party would calculate the amounts owed would change to a “Mid-Market” method. The latter called for the settlement amount to be calculated by using market rates and volatilities and by polling the dealer group as required, to be the mid-market value of the transaction as of the close of business (New York time) on the early termination date.

When LBHI filed for Chapter 11, this constituted a special trigger event. However, rather than terminating the outstanding transactions, LBDP and MSHDA entered into an assignment and amendment agreement with LBSF ' at the time, a non-debtor ' in which all of LBDP's rights and obligations under the master agreement and schedule were assigned to LBSF. The assignment agreement also amended the method used to calculate the settlement amount. The amendment's liquidation provision stated that calculation of the settlement amount would be performed using the Mid-Market method, unless terminations were due to the non-payment or bankruptcy of LBSF, in which case the Market Quotation method would be used.

LBSF subsequently filed for Chapter 11, causing MSDHA to declare an event of default, select an early termination date and to calculate the amount owed to LBSF using the Market Quotation method. According to MSDHA, the amount due was approximately $36 million. However, LBSF took the position that had MSDHA used the Mid-Market method, the amount due would exceed $59 million. Thus, the dispute hinged on the method ' Mid-Market or Market Quotation ' that properly should have been used to calculate the settlement amount.

The Issue

The bankruptcy court framed the question presented in Lehman to be what it really means for a non-defaulting swap counterparty to have the unlimited contractual right to liquidate a swap agreement, and whether that protected right properly extends to the contractually prescribed procedures for calculating amounts due and owing from one counterparty to another. In other words, the question was whether a contractual term calling for certain liquidation procedures in bankruptcy that are more favorable from the point of view of the non-defaulting party should be exempt from the rule that generally outlaws such ipso facto provisions.

The bankruptcy court noted that this question goes to the heart of this safe harbor: If the exercise of a contractual right to cause the liquidation of a swap agreement is protected, are the contractually specified means for conducting that liquidation so connected to the very concept of liquidation that they are also protected?

Lehman argued that the less favorable procedures triggered by a bankruptcy default are ineffective ipso facto alterations of a debtor's rights, and so do not fall within the safe harbor. On the other hand, MSHDA and the International Swaps and Derivatives Association, Inc. (ISDA) (in an amicus brief) argued that the protected right to liquidate cannot be viewed as an isolated right and necessarily includes those contractual provisions that provide needed guidance for liquidating and closing out the swap agreement. This dispute regarding scope was central to the meaning and purpose of this safe harbor.

The Bankruptcy Court's Ruling

The bankruptcy court found that these issues call for consideration of the literal meaning of the word “liquidation” consistent with the purposes that underlie the safe harbor for liquidating swap agreements. The court concluded that the protected right to liquidate must include a way to execute the liquidation in order to infuse the safe harbored right with meaning. The concept of an unlimited right to liquidate a swap agreement is incomplete without reference to the methodology that the parties have chosen in their contract for conducting the liquidation. That common-sense construction of the safe harbor comports with the ordinary and customary meaning of the word “liquidate” (to liquidate is to convert an asset to cash by following a set of prescribed procedures) and allows the parties, without needless delay or uncertainty, to determine the amounts payable to terminate their swap agreement with clarity and finality.

Liquidation

The bankruptcy court noted that the ordinary meaning of “liquidation” leads to the conclusion that the right to cause the liquidation of a swap agreement must mean the right to determine the exact amount due and payable under the swap agreement. The amount can only be fixed by following the liquidation methodology specified in the swap agreement. The bankruptcy court further noted that liquidation and the methodology for carrying out the liquidation are linked concepts: to liquidate is to obtain values prescribed by contract. Using the Market Quotation method to calculate the settlement amount is a necessary part of the exercise by MSHDA of its contractual right to cause the liquidation of the swap agreement with LBSF.

LBSF urged the bankruptcy court to adopt a much narrower reading of Section 560 and drew a distinction between the act of termination, liquidation, or acceleration and the method chosen for calculating a settlement amount. According to LBSF, only the acts are safe harbored and other rights, such as how to calculate the amount due, are ancillary rights and are not protected.

However, the bankruptcy court found that LBSF did not give enough weight to the phrase the exercise of any contractual right which connects with the phrase to cause the liquidation, termination, or acceleration in section 560. Read together, the act of liquidation, termination, or acceleration must be performed in accordance with a contractual provision in the swap agreement. Here, the liquidation provision specifies what that right entails. Unless the act of liquidation is performed in accordance with some agreed method, the right to liquidate is disconnected and loses all practical meaning.

Further, according to the bankruptcy court, LBSF failed to explain why a commercially acceptable method chosen by the parties themselves should not be respected or to demonstrate why it is appropriate to use the alternative Mid-Market method. The methods produce different results, but both methods are contractually approved methods for valuing collateral. The result ' whether it produces more or less value for the debtor ' should not be decisive in considering how to apply the safe harbor. The liquidation method, regardless of amounts realized, is fully baked into the very concept of what it means to liquidate. The very act of liquidating and the method for doing so are tightly intertwined to the point that liquidation without a defining methodology is impossible to perform. Simply put, to liquidate is to calculate the settlement amount under the terms of the swap agreement. These concepts (liquidation and liquidation methodology) are so closely connected to one another that they flow together and become virtually inseparable.

The Bankruptcy Court's Reasoning

The bankruptcy court noted that allowing a non-debtor counterparty to use the contractual method of liquidation promotes the systemic goals of the safe harbor ' to provide stability and certainty to the markets upon the insolvency of a counterparty and to enable the parties themselves to liquidate collateral in a contractually prescribed manner.

The bankruptcy court further noted that the protected right to cause the liquidation of a swap agreement must extend beyond the mere capacity to commence a liquidation in a vacuum, and must embrace those related terms of the swap agreement that explain the liquidation protocol to be followed when one party goes into bankruptcy. These may be ipso facto provisions, but they are exempt by statute and permitted.

The bankruptcy court distinguished its prior rulings where it held that the safe harbor provisions of Section 560 of the Bankruptcy Code do not extend to a bargained-for change in the priority of distributions between LBSF as swap counterparty and certain investors in notes issued by a special purpose vehicle. That dispute dealt with the issue of whether a so-called flip clause triggered by a bankruptcy default is an ineffective ipso facto provision.

In that earlier case the bankruptcy court found that the language of section 560 is expressly limited to the specified rights to cause the liquidation, termination or acceleration of a swap agreement and does not authorize non-defaulting parties to swap agreements to improve their standing in a waterfall and obtain higher priority distributions upon the occurrence of a bankruptcy default. S ee Lehman Bros. Special Fin. Inc. v. BNY Corporate Tr. Servs. Ltd. (In re Lehman Bros. Holdings Inc.), 422 B.R. 407 (Bankr. S.D.N.Y. 2010, a decision that was ratified and followed in Lehman Bros. Special Fin. Inc. v. Ballyrock ABS CDO 2007-1 Ltd. et al. (In re Lehman Bros. Holdings Inc.), 452 B.R. 31 (Bankr. S.D.N.Y. 2011).

The bankruptcy court stated that these earlier rulings were made with respect to impermissible changes to distribution priorities and are not controlling. Instead, the court found that the question presented was more nuanced and closer to the statutory core of section 560, leading to an examination of whether the methodology for conducting an indisputably exempt liquidation is also exempt. This time the scheme of section 560 ' namely protection of the safe harbored right to cause a liquidation ' is directly implicated in the analysis.

According to the bankruptcy court, there is a significant difference between the reordering of priorities within a hierarchy of distributions (an ipso facto contractual term that is not mentioned in Section 560) and selecting which method to use when disposing and valuing collateral in connection with liquidating a terminated swap agreement. The choice of an accepted and contractually specified method to liquidate, even if it produces a less desirable result from the point of view of the debtor, is consistent with full implementation of the exemption that is codified in section 560. The bankruptcy court determined that this provision of the swap agreement is a contractual right to cause the liquidation (i.e., to liquidate), and accordingly is squarely within the safe harbor, not outside of it.

Conclusion

Accordingly, the bankruptcy court held that the alternative approach to liquidation of collateral used by MSHDA is effective even though it is contained in an ipso facto provision because that alternative is protected by the safe harbor of section 560 and, as a consequence, is not subject to the ipso facto limitation contained in section 365(e)(1). The court concluded that when dealing with a swap agreement, the exercise by a swap participant (here, MSHDA) of a contractual right to cause a liquidation of the swap agreement in question is a unified concept because the act of causing a liquidation calls for the collection of market data in a particular manner from specified sources to obtain pricing information. For that reason, the plain meaning of this safe harbor protects both the act of liquidating and the manner for carrying it out. The act of causing liquidation and the methodology converge to the point of being one and the same. Accordingly, the procedures followed by MSHDA in determining the settlement amount were protected by the safe harbor of section 560.

Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC and a member of this publication's Board of Editors. He may be reached at
[email protected].

'