On May 30, 2014, hedge fund Moore Capital (Moore) brought suit against the Lehman Brothers bankruptcy estate (Lehman) in the Southern District of New York bankruptcy court, seeking a declaratory judgment that it acted properly when it terminated swap agreements and setoff termination amounts in the time between the filing of the parent company Lehman Brothers Holdings Inc. (LBHI) and the eve of bankruptcy filings weeks later of Moore’s Lehman counterparties1. Lehman answered and counterclaimed, challenging Moore’s early termination of the swap agreements as well as its calculation of the early termination payment made to Lehman. At its core, this dispute concerns whether and when non-defaulting parties to safe harbor contracts may assign to a third party early termination payment claims against a bankrupt counterparty and then set off such claims against amounts it owes to the bankrupt party.
Background During the summer of 2008, Moore and several of its affiliates entered into ISDA master agreements with two Lehman subsidiaries—Lehman Brothers Special Financing, Inc. (LBSF) and Lehman Brothers Commercial Corporation (LBCC). The subsidiaries’ parent, LBHI, provided credit support under those ISDAs. LBHI’s Chapter 11 filing in September 2008 triggered events of default under the ISDAs, and Moore delivered notice of the early termination of each ISDA to its counterparties. In-the-money Moore affiliates then assigned their rights to termination payments to the Moore affiliates that were out-of-the-money. The resulting setoff opportunities of such amounts were used to reduce the termination payment owed by the out-of-the-money Moore affiliates to the Lehman counterparties. LBSF and LBCC filed for bankruptcy protection on October 3, 2008. Approximately eight months later, Moore completed its valuation process and, pursuant to its early termination calculations, paid close to $60 million to Lehman. Lehman asserts that the assignments between Moore affiliates were improper and violate the setoff provisions in section 553 of the U.S. Bankruptcy Code.
Moore’s Position Moore contends that its assignments of termination payments were made in accordance with section 7(b) of the ISDA Master Agreement and were consistent with applicable bankruptcy law. Moore argues that the safe harbor protections contained in sections 362, 553, and 560 of the Bankruptcy Code permit the liquidation, termination, acceleration, netting, and setoff of obligations notwithstanding the automatic stay and the general prohibition on claim transfers in the 90-day window prior to a bankruptcy filing. Moreover, Moore argues that the provisions of section 553(a)(2)(B)(ii) expressly except safe harbored transactions, including swap agreements like Moore’s ISDAs, from the 90-day prohibition against transfers of claims. Although a number of bankruptcy courts have not permitted cross-affiliate setoff (both pre- and post-) petition, Moore argues that its assignments were not unenforceable multi-party set-offs because the assignment worked to give the assignees their own rights under the respective ISDAs, thus creating the requisite mutuality of parties for the setoff to be enforceable, and regardless, the early terminations and assignments of claims were conducted prior to the Lehman counterparties entering bankruptcy.
Lehman’s Position Lehman argues that Moore’s assignments occurred after LBSF and LBCC filed for bankruptcy protection and are thus prohibited by the automatic stay and the anti-claim-trafficking provisions of section 553 of the Bankruptcy Code. Alternatively, if the transfers were made prior to the LBSF and LBCC filings, Lehman argues that section 553(a)(2)(B)(i) of the Bankruptcy Code prohibits transfer of claims against the debtor within the 90-day period prior to a bankruptcy filing. Lehman also argues that the assignments were the economic equivalent of cross-affiliate setoff and should be prohibited notwithstanding the safe harbor provisions because (a) pre-petition, Moore did not elect cross-affiliate netting and setoff in the ISDAs, and (b) post-petition, cross-affiliate netting and setoff violates section 553.
Conclusion The court’s determination of these issues may turn on the facts—the timing of the transfers—but may also turn on the interpretation of the scope and intent of the applicable safe harbor provisions concerning setoff rights. Parties to ISDA agreements should carefully monitor this case, as the outcome could shape the enforceability of ISDA section 7(b) vis-a-vis the Bankruptcy Code and the strategic analysis of counterparties following a counterparty’s or credit support provider’s bankruptcy. This case also serves as a reminder to parties to be cautious when assuming all contractual provisions in industry-standard master agreements will be enforceable, as this case confirms that contractual provisions seeming to reflect the intent of the parties may still be called into question before a court.