On September 15, 2008, Lehman Brothers Holdings Inc. filed a voluntary petition for bankruptcy protection, commencing the largest bankruptcy case in U.S. history. Initially, it appeared that many of the operating subsidiaries would remain outside of bankruptcy, but during the past several days, many of them have filed bankruptcy petitions as well. As of this writing, a complete list of the bankrupt Lehman entities (collectively, “Lehman”) is as follows:

  • Lehman Brothers Holdings Inc. 
  • LB 754 LLC 
  • PAMI Statler Arms LLC 
  • Lehman Brothers Commercial Corporation 
  • Lehman Brothers Commodity Services Inc. 
  • Lehman Brothers Derivative Products Inc. 
  • Lehman Brothers Financial Products Inc. 
  • Lehman Brothers Finance SA 
  • Lehman Brothers OTC Derivatives Inc. 
  • Lehman Brothers Special Financing Inc. 
  • Lehman Brothers Inc. (in a SIPC proceeding administered by the bankruptcy court)

The above list of debtor entities is likely to include most Lehman counterparties to derivatives contracts. Accordingly, market participants must be aware of their rights and what they must do to preserve those rights.

The first inquiry should be whether the counterparty is able to terminate its agreements with Lehman. This inquiry entails an analysis of the contractual provisions concerning default and termination. Be aware that the right to terminate may arise not only from the counterparty’s insolvency, but also from the insolvency of its credit support provider (e.g., guarantor) or an affiliate (e.g., a Specified Entity designated under an ISDA Master Agreement). In some cases, termination is automatic on the occurrence of the insolvency; in others, an express termination by the party that is not insolvent must occur. Even if the counterparty has the right to terminate, it should analyze the agreement’s close-out provisions to determine whether and when it is desirable for it to do so. Once a decision is reached to terminate the agreement, the counterparty should notify the debtor entity of the termination in accordance with the contractual provisions.

Once a derivatives contract is terminated, then the counterparty must heed the provisions concerning the calculation of a termination payment. The counterparty should make its calculations as quickly as possible and then convey those calculations to the debtor entity. For more detail concerning the close-out process upon a bankruptcy default, please click here to see our alert entitled “Lehman Brothers Bankruptcy–ISDA Issues,” dated September 15, 2008.

Automatic Stay

Bankruptcy law generally imposes an automatic stay, prohibiting most actions against the debtor in bankruptcy and its property. In many cases, however, those provisions do not apply to trading counterparties that exercise their rights under derivatives contracts. For example, Section 362(b)(17) permits a counterparty to an ISDA Master Agreement to exercise its contractual rights to setoff or net termination payments across contracts. The Bankruptcy Code prohibits most typical creditors from exercising setoff rights under a non-trading contract.

Courses of Action

If the counterparty is owed money by Lehman, then it likely has several separate courses of action to consider:

  • If the counterparty believes that Lehman is holding excess collateral that should not be property of the bankruptcy estate, then the counterparty will likely need to commence a legal action to recover the collateral. The time frame for the resolution of such a proceeding will be determined by the court, but it is unlikely to lead to any immediate access to the excess collateral. 
  • If Lehman simply owes a termination payment or other payment under the relevant agreements, then the counterparty should file a proof of claim. In coming weeks, the bankruptcy court will set a deadline for the filing of claims. The first page of a proof of claim must be on an official form, but the counterparty should attach as much supporting documentation as is necessary to demonstrate the amount owed. To the extent that the counterparty has claims against multiple bankrupt entities, separate claims should be filed against each such Lehman entity, including under a guaranty. 
  • If the counterparty is holding collateral, the Bankruptcy Code does not prevent a counterparty’s exercising its setoff rights under a derivatives contract. Thereafter, if the counterparty is still owed additional money by Lehman, it should file a proof of claim for the balance. If, on the other hand, the counterparty holds excess collateral, then Lehman may file an action in the bankruptcy court to have the counterparty return those funds to the bankruptcy estate.

After Filling the Proof of Claim

Lehman has retained a claims agent, which will accept and record all proofs of claim. After filing a proof of claim, the counterparty will likely face a prolonged wait before it realizes any payments. Lehman will have an initial 120-day period to file a plan of reorganization; that period may be extended to 18 months from the bankruptcy filing. Courts usually grant such extensions and, as a result, the plan of reorganization might not be filed until March 2010. Thereafter, there is a period of time before the bankruptcy court can confirm the plan. After plan confirmation, there is often a short delay before the plan becomes effective; and even once effective, distributions on claims will generally be sent only in incremental amounts over a number of months.

In the interim between the counterparty’s filing of the claim and the ultimate payout, Lehman will closely review the amounts and validity of the claims filed against it. If it agrees with the amounts claimed, then it will take no action. After a certain amount of time passes without an objection filed, the claim would become an “allowed claim.” Only allowed claims are eligible for distributions. If, on the other hand, Lehman disagrees with the amount or basis for any given claim, then it could file an objection to that claim. A claim objection commences a contested matter that represents a condensed version of litigation. If the parties are unable to reach an agreement, then the court would hold an evidentiary hearing and make a final determination as to whether the claim should be an allowed claim and in what amount.

The summary above provides a high-level summary of the bankruptcy procedure facing Lehman counterparties. Each counterparty will likely face individualized issues based on its unique set of facts. Any specific actions to be taken in this matter should be based on a thorough review of the applicable contracts and underlying transactions, all of which could modify the general observations provided above. Please contact us if you need assistance or have any questions.