Earlier today (September 15, 2008), Lehman Brothers Holdings Inc. (Holdings), the corporate parent of the fourth largest investment bank in the United States, filed for Chapter 11 protection in the United States Bankruptcy Court for the Southern District of New York. As of writing, neither Holdings’ broker-dealer subsidiaries (including Lehman Brothers, Inc. [Lehman NY]) nor other subsidiaries (including Neuberger Berman Holdings, LLC, its asset management subsidiary) have commenced insolvency proceedings in the United States. Holdings has stated that it is exploring the sale of its broker-dealer operations and is in advanced discussions with a number of parties regarding the possible sale of its Investment Management Division. Several of Holdings’ U.K. subsidiaries have reportedly been placed into administration by U.K. regulators.
This bulletin is to alert you, particularly if you have counterparty risk, regarding the effect of Holdings’ insolvency and potential insolvency proceedings of its subsidiaries. The Bankruptcy Code contains a number of special provisions that enable a nondebtor counterparty, without restriction, to terminate, liquidate or accelerate its securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements or master netting agreements with the debtor. These particular provisions redefine specified financial contracts, agreements and transfers; revise guidelines governing transfers of qualified financial contracts of an insolvent institution; and provide for the repudiation of qualified financial contracts and the treatment of master agreements as a single qualified financial contract.
The Bankruptcy Code provides three essential benefits to certain parties to financial contracts with a debtor: (i) authorizes parties to set off amounts owed by a debtor to a party against collateral in the hands of the non-debtor party without violating the automatic stay in place as of the filing of the bankruptcy; (ii) protects payments to a party to certain contracts from the debtor that would otherwise be recoverable as “preferential” or fraudulent transfers; and (iii) authorizes parties to terminate certain financial contracts with debtors solely on the basis of the debtor’s bankruptcy filing.
These provisions are extremely beneficial to parties to financial contracts with debtors. By allowing counterparties these remedies, Congress hoped business would be conducted without significant interruption. Whether a contract, a party to a contract or payment received from a debtor qualifies for these exemptions requires an analysis of the specific situation.
In analyzing these contractual arrangements it is important to determine the specific Lehman entity involved, its status as a filed, non-filing or receivership entity, and whether or not the contractual rights allow for remedies based on the filings of affiliated entities.
Broker-dealer insolvencies are not permitted to file for Chapter 11 protection. They are usually governed by the Securities Investor Protection Act (SIPA), under which the Securities Investor Protection Corporation (SIPC) appoints a trustee to liquidate the broker-dealer and protect customer funds. Accordingly, SIPA was also amended to provide that neither a filing of a protective decree by SIPC nor any court protective order shall operate as a stay against a creditor’s contractual right to liquidate, terminate or accelerate designated contracts and agreements. Companies that use Lehman NY as a broker will be concerned whether Lehman NY commences a Chapter 7 liquidation under the Bankruptcy Code or a liquidation under SIPA and whether the accounts become frozen. The assets in the funds will have to be accounted for, as well as whether these assets served as collateral for Lehman entities.
Two scenarios may exist for companies involved in financial contracts. First, you may be a party to a derivatives contract with a Lehman entity. This exposure could be troublesome because banks and investment banks do not usually provide collateral or other credit support to back up their derivatives obligations. As a result, counterparties to Lehman may be unsecured creditors with respect to any amounts they are owed by Lehman entities (whether directly or under parent guarantees) that commence insolvency proceedings. Swap parties will have to determine whether the Lehman entity is a debtor and whether they have setoff and termination rights under the terms of their contracts.
Second, a Lehman entity may be the underlying entity referenced in the contract – that is, the entity on which payment obligations under the contract are based. Such exposure is likely to be in the form of a credit default swap with a Lehman entity as the “Reference Entity.”
Since the vast majority of derivatives contracts are drafted using the standard form agreements of ISDA (International Swaps and Derivatives Association), the association is playing its usual role of devising standard procedures and protocols to deal with the consequences of the bankruptcy and has released statements about both the scenarios set out above.
With respect to the first scenario, ISDA reminds parties to derivatives contracts to review their agreements with Lehman and consult legal counsel as appropriate. If it is determined that an event of default has taken place, agreements based on ISDA forms will contain a procedure for terminating all transactions outstanding under the agreement and determining the single net amount owed by one party to the other. As became evident to Torys lawyers during the Enron case, unless the contract terminates on the insolvency of an affiliated company, the bankruptcy protections for terminating financial contracts may not be available if the counterparty is a non-debtor subsidiary of Holdings.
With respect to the second scenario, ISDA advises that it intends to perform its usual role in relation to any auction settlement of credit derivatives trades that make reference to a Lehman entity.
Additionally, companies may be part of a syndicated loan facility with a Lehman entity as a co-lender or an administrative agent. The underlying credit documents should be analyzed to determine the obligations of the Lehman entity and whether it can fulfill administrative duties or lending obligations, whether the particular entity is shielded from or becomes part of a bankruptcy case.
Finally, companies may be interested in purchasing Lehman assets as part of a distressed sale. We will monitor the bankruptcy case for sale procedures for both debtor and non-debtor assets. In similar mega filings where not all subsidiaries became debtors, such as with Enron, sales of assets of non-debtor subsidiaries were subject to limited review and consent by the bankruptcy court.