On September 15, 2009, the United States Bankruptcy Court of the Southern District of New York ordered Metavante Corporation (“Metavante”) to make payments to Lehman Brothers Special Financing Inc. (“LBSF”) under a prepetition interest rate swap agreement guaranteed by Lehman Brothers Holdings Inc. (“LBHI” and, together with LBSF, “Lehman”) after Metavante had suspended ordinary course settlement payments under the swap.1 Metavante claimed a contractual right to withhold payment under Section 2(a)(iii) of the 1992 ISDA Master Agreement as a result of Lehman’s bankruptcy. Despite the clear and specific contractual right to withhold payment where an event of default has occurred and is continuing, in this case the Lehman bankruptcy, the Court held that such suspension of payments was in violation of the automatic stay provision2 of the United States Bankruptcy Code (the “Code”) and not protected by the applicable safe harbor provisions.3

Background

Lehman and Metavante entered into a 1992 ISDA Master Agreement (and related Schedule) on November 20, 2007 (the “ISDA Master Agreement”) and executed a transaction confirmation in respect of an interest rate swap on December 4, 2007 (together with the ISDA Master Agreement, the “Swap Agreement”). Under the transaction, Metavante was obligated to pay LBSF a fixed rate on an amortizing notional amount until February 1, 2012, and LBSF was obligated to pay Metavante a floating rate based on three-month LIBOR on the same notional amount during the same period. LBHI and LBSF filed for bankruptcy on September 15, 2008 and October 3, 2008, respectively.

Under Section 2(a)(iii)(1) of the ISDA Master Agreement, the payment and delivery obligations of a party are subject to the condition precedent that no event of default or potential event of default has occurred and is continuing with respect to its counterparty.

The ISDA Master Agreement provides that it shall constitute an event of default should a party to the agreement or any credit support provider of such party institute a proceeding seeking a judgment of insolvency or bankruptcy, or any other relief under any bankruptcy insolvency law or similar law affecting creditors’ rights.4 Also, under the terms of the ISDA Master Agreement, upon an event of default the non-defaulting party may terminate all the transactions under the ISDA Master Agreement, but it is not obligated to do so. Upon the designation of an early termination date under Section 6(a) of the ISDA Master Agreement, the non-defaulting party is required to calculate a final payment on a net basis.

As a consequence of Lehman’s filing for bankruptcy, Metavante elected in accordance with the terms of the Swap Agreement not to terminate the trade under Section 6(a) of the ISDA Master Agreement. In addition, it chose to withhold its payments to LBSF on the basis that the Lehman bankruptcy was an event of default under Section 5(a)(vii) of the ISDA Master Agreement which allowed Metavante to withhold ordinary course settlement payments as provided under Section 2(a)(iii) of the ISDA Master Agreement.

The Metavante Decision

The Order

On May 29, 2009, LBSF filed a motion requesting the Court to compel performance by Metavante of its obligations under the Swap Agreement. LBSF contended that Metavante owed in excess of US$6 million, representing quarterly payments due November 2008, February 2009 and May 2009, plus default interest in excess of US$300,000. LBSF also argued that Metavante’s attempt to suspend payments was in violation of the automatic stay provisions of the Code, and not protected by the safe harbor provisions in Sections 560 and 561 of the Code. The Court agreed with Lehman. In an Order dated September 17, 2009, 5 the Court required Metavante to pay LBSF unpaid amounts including default interest which totaled over US$6.6 million and resume payments in accordance with the terms of the Swap Agreement.

Bankruptcy Code Provisions

To provide context and better appreciate the Metavante decision, we have provided a summary of the relevant bankruptcy provisions relied upon by the Metavante court.

I. Automatic Stay

Section 362 of the Code provides that the filing of a petition for bankruptcy has the effect of imposing an automatic stay on the debtor’s affairs. The automatic stay gives the debtor protection from its creditors by preventing creditors from acting in a manner that would put at risk the bankrupt’s estate, either by attempting the enforcement of new claims or avoiding payment obligations, which may be deemed by the Court to be an attempt by the creditor to control the bankruptcy estate.

II. Executory Contracts

Though there is no precise definition of what contracts are executory under the Code, an executory contract is generally regarded by the courts as a contract where performance remains due by both parties. Under Section 365(a) of the Code, a debtor subject to a bankruptcy proceeding may, subject to the Court’s approval, assume or reject any executory contract after filing for bankruptcy. During the period of time that a debtor determines whether to assume or reject an executory contract, the contract is generally thought of as remaining “in effect” and the non-debtor parties are bound to honor it and continue to perform.

III. Ipso Facto Clauses

Ipso facto clauses are very common in contracts. These clauses terminate or modify the rights or obligations of a contract as a result of a bankruptcy or insolvency of a party. Their enforceability, however, is uncertain under the Code. Section 365(e) of the Code renders ipso facto clauses unenforceable with certain exceptions that are not relevant here.6

IV. Safe Harbor Provisions

The Code contains safe harbor provisions for qualifying derivative contracts. Of these, Sections 560 and 561 of the Code are relevant to the Metavante case. In general, the safe harbor provisions are designed to provide the non-debtor counterparties with specified rights to terminate, liquidate or accelerate qualifying derivatives contracts and offset or net out related transactions notwithstanding the bankruptcy filing of its counterparty. A party claiming the benefits of the safe harbor provisions avoids being subject to the automatic stay provision of the Code and is thus not obligated to continue to perform but has the option to terminate and net out its qualifying derivatives contracts with the debtor.

The Court’s Reasoning and Interpretation of the Bankruptcy Code

The main conclusions of the Court are as follows:

  • The rights under the safe harbor provisions to terminate, liquidate or accelerate a contract prepetition are available only to the extent that the counterparty seeks to take such actions promptly after its counterparty’s filing for bankruptcy. All other uses of ipso facto clauses are and remain unenforceable.
  • LBSF is entitled to continued payments under the Swap Agreement, and Metavante’s suspension of its payment obligations to LBSF constitutes an attempt to control property of the bankruptcy estate and is therefore a violation of the automatic stay provisions of the Code.
  • The Swap Agreement is a “garden variety” executory contract subject to the automatic stay provisions of the Code.
  • The safe harbor provisions permit qualifying non-debtor counterparties of swap transactions to terminate their derivatives contracts through the exercise of certain limited debtor contractual rights.
  • The safe harbor provisions specifically permit termination solely because of a condition of the kind specified in Section 365(e)(1), that is, the insolvency or commencement of the bankruptcy case by the debtor.
  • Metavante’s window to terminate, liquidate or accelerate its swap with LBSF with the benefit of the safe harbor provisions of the Code had expired, and its failure to act, constitutes a waiver of its right to avail itself of the safe harbor provisions for such purposes at this point in time—that is to say, one year after the filing for bankruptcy by Lehman.

Metavante argued that while it has a right to terminate the Swap Agreement pursuant to the ISDA Master Agreement and was protected in doing so under the Code by the safe harbor provisions, neither the ISDA Master Agreement nor the Code required it to exercise this right to terminate within any specific timeframe. It argued that this right was retained and may be exercised at any point in the future and that in the interim it availed itself of the contractual right under Section 2(a)(iii) to withhold payment as a result of Lehman’s bankruptcy. Metavante also argued that imposing on it an obligation to exercise its early termination rights under the Swap Agreement would render ineffective its rights under Section 2(a)(iii).

Had Metavante terminated the Swap Agreement at the time of Lehman’s bankruptcy filing, it would have been subject to large payments to LBSF. For that reason, in reliance of its Section 2(a)(iii) contractual rights to withhold payments upon an event of default, Metavante withheld payments and to avoid future losses entered into a replacement hedge covering the period from November 3, 2008 through February 1, 2010, deciding to wait for the market value of the swap transaction to move in its favor. The Court, however, disapproved of Metavante’s conduct of “…riding the market for the period of one year, while taking no action whatsoever” and considered it as “simply unacceptable and contrary to the spirit of [the safe harbor] provisions of the Bankruptcy Code.”

The Court ruled that Metavante was not entitled to protection under the safe harbor provisions because Metavante had not “terminated, liquidated or accelerated” the Swap Agreement as provided in the safe harbor provisions of the Code, and had moreover forfeited its safe harbor rights because in order to preserve such rights, Metavante had to act in respect thereof either immediately or “fairly contemporaneously with the bankruptcy filing.” According to the Court, Metavante’s failure to act constituted a waiver of its rights under the safe harbor provisions. The Court reasoned that legislative history evidences Congress’ intent to allow for the prompt closing out or liquidation of open accounts upon the commencement of a bankruptcy case. The Court also expressed the view that the stated rationale for the immediate termination for default and the netting provisions are critical aspects of swap transactions and are necessary for the protection of all parties in light of the potential for rapid changes in the financial markets.

As a result of Metavante’s failure to act in due course, the Court agreed with Lehman that the Swap Agreement was, in effect, an executory contract subject to the automatic stay provisions of the Code. Metavante’s attempts to control LBSF’s right to receive payment under the Swap Agreement constituted an attempt to control property of the estate, a violation of the automatic stay provisions. Consequently, pursuant to the Order, the Court compelled Metavante to perform its obligations to make payments to LBSF under the Swap Agreement, including but not limited to promptly making all payments that were, without regard to any alleged defaults by LBSF under the Swap Agreement, owed to LBSF.

Implication of the Metavante Decision

The Metavante decision can be contrasted with the 2004 decision by the Australian Supreme Court of New South Wales in Enron Australia v. TXU Electricity, which upheld a counterparty’s contractual right to withhold payment pursuant to Section 2(a)(iii) of the ISDA Master Agreement. There, an event of default occurred under the ISDA Master Agreement when Enron Australia was placed into administration and then into liquidation. Like Metavante, TXU Electricity (“TXU”), did not designate an early termination date and simultaneously withheld payments to Enron Australia pursuant to its right to that effect under Section 2(a)(iii) as a result of Enron Australia’s bankruptcy. Enron Australia’s liquidator requested the Court to order TXU to determine the amount which would be payable under the ISDA Master Agreement, as if TXU had designated an early termination date and that this amount be payable. The Court found that it did not have the power to vary the contract in a way that would create an obligation that did not arise from the existing terms of the contract. In finding that the court was not empowered to make such an order, the Court noted that the insolvency laws of Australia did not “permit the Court to deprive the counterparty of its contractual rights, such as the right not to designate an Early Termination Date under Section 6(a) after an Event of Default occurs” or the right to suspend payments upon an event of default under Section 2(a)(iii).6

Unlike the Metavante decision, the Australian court upheld the non-debtor party’s decision to withhold payments as a result of its counterparty’s insolvency proceeding and its right to refrain from exercising its right to terminate the contract under the ISDA Master Agreement. The decision upholds the “flawed assets doctrine” which is accepted in English and Australian law. The TXU court in upholding the “flawed assets doctrine” recognized that the “asset” (i.e., the contract) cannot be accepted by the liquidator without the “flaw” and therefore could not alter the terms of the contract. In the US, the Code is very far reaching in giving the US bankruptcy courts power to declare unenforceable ipso facto clauses in debtors’ contracts and thus requiring them to continue to perform or terminate if they may avail themselves of the safe harbor provisions.

One issue of note that was not addressed by the Court in its decision is that the initial event of default under the Swap Agreement was a default triggered by the bankruptcy of a third party, LBHI. It was argued by Metavante that this was an independent event of default. Lehman countered that under Section 365(e)(1) of the Code (which makes ipso facto clauses unenforceable), with specific reliance upon Section 365(e)(1)(B) of the Code, that any provision which adversely affects the rights of a debtor under an executory contract by reason of the bankruptcy not only of the debtor but of any third party is an ipso facto clause and is therefore not enforceable. The bankruptcy court did not expressly address this argument but by finding in favor of Lehman, the court arguably accepted Lehman’s position and ignored the distinction for purposes of its ruling.

The Metavante decision may have an important impact on future derivatives contracts in the US market. It brings into question the enforceability of a counterparty’s contractual rights under the ISDA Master Agreement to withhold payment before a US Bankruptcy Court. The decision by the Court reflects the bankruptcy judges’ far reaching power to protect the rights of the debtor and obligations owed to such debtor. In this case, this power effectively nullifies a derivatives counterparty’s contractual right to withhold payment under the ISDA Master Agreement for purposes of US bankruptcy law. At best, the right is now extremely uncertain. It is not clear what effect this ruling will have, if any, on trading by market participants in the US and elsewhere. It will be interesting to see how markets will respond.

Finally, Metavante has now filed a motion seeking clarification of the LBSF’s future obligations to Metavante and the amount that Metavante owes as default interest under the Bankruptcy Court’s Order. The motion raises interesting issues for the Court to consider. One of these is particularly so. Metavante argues in the motion that, as a result of the Court’s ruling, Lehman now has the right to ride the market and reject the contract if ever the market turns against Lehman. As noted above, this is precisely the perceived behavior by Metavante that met with the Court’s disapproval.