Beginning on September 15, 2008, Lehman Brothers Holdings Inc. (“LBHI”) and 16 of its affiliates (the “Debtors”) filed voluntary Chapter 11 bankruptcy petitions with the United States Bankruptcy Court for the Southern District of New York. The resulting bankruptcy cases are jointly administered by the bankruptcy court for procedural purposes (collectively, the “Chapter 11 Proceeding”), but to date, the Debtors remain separate legal entities.  

Soon thereafter, the Securities Investor Protection Corporation applied for an Order Commencing Liquidation of Lehman Brothers Inc. (“LBI”) under the Securities Investor Protection Act of 1970 (“SIPA”). On September 19, 2008, the U.S. District Court for the Southern District of New York issued an order approving the application and appointing James. W. Giddens as the Trustee of the case. The bankruptcy court is administering a separate proceeding (the “SIPA Proceeding”) for the liquidation of LBI under SIPA.  

Claim Deadlines

In the SIPA Proceeding, the court has set bifurcated deadlines for the filing of claims. All customers seeking maximum protection under SIPA must have their claims submitted so as to be received by the trustee by January 30, 2009. Likewise, claims by broker-dealers for the completion of open contractual commitments must be received by the trustee no later than January 30, 2009. All other claims must be filed in time for the claims to be received by the trustee by June 1, 2009.  

In the Chapter 11 Proceeding, the bankruptcy court has not yet set any deadline for the filing of proofs of claim.  

Motion on Lehman’s Assignment Right and Settlement Procedure

On November 13, 2008, LBHI and its affiliates (collectively, “Lehman”) filed a Motion for an Order Pursuant to Sections 105 and 365 of the Bankruptcy Code to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivative Contracts (“Motion”). The Motion sought to implement procedures for (a) the assumption and assignment of unterminated derivatives contracts, and (b) the settlement of controversies related to derivatives contracts.  

While 101 counterparties objected to the Motion, most of objections were resolved consensually. After a hearing on December 16, 2008, the court entered an order establishing those procedures. As noted below, the remaining objections will be heard at a hearing on January 14, 2009.  

Assumption and Assignment Procedures

Lehman asserts that it had approximately 930,000 derivatives contracts as of the petition date. Of those, approximately 900,000 contracts have been terminated and 30,000 remain open. In many of those open contracts, Lehman is in the money but cannot collect its receivables because of “condition precedent” language, such as that found in Section 2(a)(iii) of the ISDA Master Agreement. Such condition precedent provisions exempt counterparties from their payment obligations because of the occurrence of an Event of Default, often based upon Lehman’s bankruptcy filings.

Lehman therefore sought in the Motion to monetize the “embedded assets” of those receivables. The Motion proposed to allow Lehman to assume these derivatives contracts, cure any monetary defaults thereunder, and assign these contracts to third parties. In so doing, Lehman hoped to realize some value from the third parties’ bidding for such receivables.  

Many counterparties objected to the modification of their contractual rights and the lack of transparency in Lehman’s selection of assignees. To resolve those objections, Lehman worked with the objecting counterparties and the creditors’ committee to craft a consensual order that was more palatable to the counterparties. At the December 16 hearing, the bankruptcy court approved the revised procedures, stressing the importance to international commerce for Lehman to have the ability to assign some of its positions. To the extent that some parties’ objections remain unresolved, those counterparties will not yet be subject to the procedures and will have their objections heard on January 14, 2009. Those counterparties include some of the major dealers such as Citibank, Standard Chartered Bank, the Bank of New York Mellon, Société Générale, Canadian Imperial Bank of Commerce, as well as Bank of America, certain Deutsche Bank affiliates and Wells Fargo acting in the capacity as trustees.  

As a result, comprehensive procedures are now in place to allow Lehman to assume and assign those derivative contracts that have not been terminated. If Lehman wishes to assume and assign such a contract, it must provide a “Notice” to the counterparty. The Notice must contain the identity of the proposed assignees, the cure amount that Lehman proposes to pay and certain other information. Depending on the size of the contract, the counterparty has either 10 or 20 business days after the delivery of the Notice during which to object. An objection may be based on any of five grounds: (1) the cure amount, (2) the need to cure a default other than the default relating to Lehman’s bankruptcy filings, (3) the adequate assurance of the assignee’s future performance, (4) an allegedly valid termination of the derivative contract, and (5) the identity of the assignee. If a counterparty fails to object within the prescribed period, it is deemed to have consented to the proposed cure amount and all other preconditions of the assumption and assignment.  

If Lehman is unable to resolve the timely delivered objections, it must seek court approval to assume and assign the contract. Lehman has 60 days from the expiration of the objection period to assume and assign the relevant contract; otherwise, its authority to do so lapses and it must serve another Notice to begin the procedure again. If Lehman actually assigns the contract, then all defaults and termination events are deemed cured. As a result, the condition precedent language in Section 2(a)(iii) of the ISDA Master Agreement could no longer be asserted to the extent this right arises due to Lehman’s defaults.  

Settlement Procedures

In ordinary circumstances, the Federal Rules of Bankruptcy Procedure require a trustee or debtor-in-possession to receive court approval of the settlement of any dispute. Because of the volume of counterparties, Lehman believed that its adherence to that rule would be impracticable for both Lehman and the bankruptcy court. It therefore proposed procedures allowing it to settle claims related to terminated derivatives contracts. The bankruptcy court approved those procedures on December 16 as well.  

The procedures allow Lehman to settle with the counterparties to any derivatives contract or master netting agreement. A settlement may fix the settlement amounts or termination payments between the parties to a terminated contract. It may also incorporate setoff or recoupment rights, to the extent that such rights are legally valid and enforceable. Any such settlement will be effective according to the terms of the agreement, without the need for further action by the bankruptcy court.

As evidenced by the high number of objections filed, the Motion generated some controversy in the world of derivatives counterparties. Some observers complained that the Motion eliminates significant counterparty protections. Nevertheless, the bankruptcy process is essentially about the modification of contractual rights, and it should not be terribly surprising to see the condition precedent provisions abrogated. In granting the Motion, the bankruptcy court may have served the common good in maximizing the value of the bankruptcy estate. Individual counterparties, however, should examine their specific circumstances closely to see whether their rights are likely to be affected by these procedures.