On January 25, 2011, Lehman Brothers filed an amended version of its plan of liquidation (the Plan). Contrasted against its predecessor version, the Plan creates some winners and some losers in terms of the percentage of projected payouts to creditors of various Lehman entities. More important than the percentage distribution, however, may be the means by which the debtors seek to fix a creditor’s claim amount. With regard to claims based on derivatives contracts, Lehman proposes to take a novel – and for holders of those claims, potentially alarming – approach.
Lehman filed its first version of a plan in April 2010. In it, Lehman proposed to maintain the corporate distinctions of each debtor affiliate, as opposed to substantively consolidating them into one Lehman entity. By observing corporate formalities, the proposal provided for payment of each affiliate’s individual liabilities out of its own assets.
That decision drew fire from holders of claims against the parent company, Lehman Brothers Holdings Inc. (LBHI). Because it issued many parent company guaranties, LBHI’s books reflect a heavy debt load. Meanwhile, most of Lehman’s assets reside at the subsidiary level. Accordingly, certain holders of LBHI claims formed an ad hoc committee to advocate for a different treatment of their claims. Toward that end, they filed a rival plan earlier this year, which would provide for the substantive consolidation of nearly all debtor affiliates into one Lehman entity. As a result, under the substantive consolidation plan, holders of LBHI claims would fare better and holders of claims against certain operating companies would fare worse than they would have under the original version of Lehman’s plan.
In its present version of the Plan, Lehman seeks to strike a compromise between those two positions. Accordingly, it retains the corporate formalities of the debtor affiliates, but features a redistribution of certain portions of the payouts to certain creditors. As an outreach to the creditors of LBHI, the Plan provides for creditors of certain operating companies to forfeit between 20% and 30% of their payouts, which is then funneled back to LBHI creditors.
In part as a result of the redistribution, projected payouts to creditors are significantly different from those under the previous version. Derivatives-based creditors of Lehman Brothers Special Finance Inc. (LBSF) and Lehman Brothers Commercial Corp. (LBCC) are estimated to receive slightly less, as are holders of LBHI claims based on its guaranty of derivatives contracts. Conversely, the projected payout to other holders of LBHI claims rises materially. So too does the estimate for holders of derivatives-based claims against Lehman Brothers Commodity Services Inc. (LBCS), which was one of Lehman’s energy trading arms.
The table below shows projected payouts to some relevant classes of creditors, under both the current Plan and its predecessor version:
Click here for table
More controversially, the Plan refers to a yet-to-be proposed mechanism – called the “Derivative Claims Framework” – for determining the allowed amount of derivatives-based claims. Lehman emphasizes the complicated and time-consuming nature of the valuation of derivatives claims. Moreover, it contends that some derivatives-based claims were asserted in amounts that significantly exceed its internal valuations. Therefore, the Plan indicates that Lehman will seek approval of the Derivative Claims Framework, which is a standardized methodology for valuing derivatives-based claims. Lehman suggests that the basis for creating the Framework is to “avoid the costs and delay of litigating these disputes individually.” The Plan provides little detail as to the actual contents of the Framework.
It may be true that the Derivative Claims Framework will reduce time and expenses for the debtors, but it appears that the Framework would provide Lehman with other benefits as well. By creating its own methodology – and prospectively having the bankruptcy court approve it as the sole valuation mechanism – Lehman seeks to eliminate counterparties’ contractual rights. Nearly every derivatives contract provides for the ability of the non-defaulting party to value any transactions that are subject to early termination, but the Derivative Claims Framework would serve to short-circuit those contractual rights.
In the Plan, Lehman tips its hand on some of the features of its Framework. In discussing the purported need for a standardized methodology, Lehman comments: “There are various reasons for the diverging valuations, including the time and date of such valuation, utilizing the bid/ask price as opposed to the mid-market price, the inclusion of additional amounts added to the mid-market prices, and setoff.” From that statement, one might infer that the debtors intend to use the Framework as a means to impose upon counterparties rules that are outside of industry norms. For example, Lehman apparently seeks to prohibit the use of the bid/ask spread in valuing termination damages. Likewise, it appears that Lehman will use the Framework as its tool for continuing to restrict the scope of counterparties’ setoff rights.
As of now, the Derivative Claims Framework is only a topic for discussion. The Plan indicates that Lehman will seek authority to implement the Framework in a separate motion, rather than as part of the Plan. So far, no such motion has been filed, and the relevant details of the Framework remain unknown.
Nevertheless, it is foreseeable that the motion seeking approval of the framework will initiate a very big struggle between Lehman and its sizable body of derivatives counterparties. Because the issues at stake involve the enforceability of major contractual rights that pervade throughout the industry, it is also foreseeable that industry trade groups may want to join in the battle. Regardless, it will be important for Lehman counterparties to scrutinize the contents of the Framework to ensure that it would result in a fair treatment of their rights. The slightest modifications of valuation methodologies could have significant effects on the outcome of those counterparties’ claims, and their overall recoveries.