On September 15, 2008, Lehman Brothers Holdings Inc. (“LBHI”) filed for protection under chapter 11 of the United States Bankruptcy Code in New York. The case bears the caption In re Lehman Brothers Holdings Inc., Case No. 08-13555, and has been assigned to Judge James M. Peck. Notably, the only Lehman entity thus far to file for chapter 11 protection is LBHI; neither the main “broker dealer” (Lehman Brothers, Inc.) nor other subsidiaries of Lehman filed for U.S. bankruptcy protection. However, Lehman Brothers Japan Inc. and Lehman Brothers Holdings Japan Inc. have both filed for bankruptcy protection in Tokyo and Lehman Brothers International (Europe) Ltd. (“LBIE”), Lehman’s main European broker-dealer, Lehman Brothers Ltd., LB Holdings PLC and LB UK RE Holdings Ltd. filed for administration in the United Kingdom. Under most Lehman ISDA Agreements, LBHI is specified as “Credit Support Provider” for LBIE and Lehman Brothers Special Financing Inc. (“LBSF”). Lehman has stated publicly its intention to operate its businesses in transition to orderly sales, to the fullest extent possible. To that end, LBHI has obtained “first day” Bankruptcy Court orders allowing it to continue to clear trades through JPMorgan Chase Bank, N.A. and has announced to its creditors its intention to sell Lehman Brothers Inc. (“LBI”) through a Securities Investor Protection Act proceeding for approximately $1.7 billion in cash plus certain assumed liabilities to Barclays Bank and to close the sale by the end of this week. Lehman has also requested Bankruptcy Court authority to enter into a $450 million financing facility. Absent bankruptcy filings by its subsidiaries, dealings with non-filing entities will not involve the Bankruptcy Court. It will, therefore, be important to follow the entire situation as it continues to unfold.
The chapter 11 filing of LBHI does have some immediate consequences. These include primarily the imposition of an automatic stay, or injunction, prohibiting a creditor taking any action against LBHI to collect on its claim or exercise control of any kind over LBHI’s property. The automatic stay is not absolute, however. We discuss below important protections that exist for certain kinds of financial products.
- Prime Broker Agreements. LBI has not filed for bankruptcy and as a broker dealer it is not eligible for chapter 11 protection; however, it is eligible to commence chapter 7 liquidation proceedings. If LBI does file for chapter 7, securities it holds for its customers could be frozen and other consequences could impact a customer’s ability to collect from LBI.
- Repurchase Agreements. As set forth in LBHI’s bankruptcy filings, as of May 31, of the $613 billion in debt, approximately $188 billion is covered by repurchase agreements. Under Section 559 of the Bankruptcy Code, the automatic stay does not apply to the liquidation of a repurchase agreement. To the extent LBHI is party to an agreement that constitutes a “repurchase agreement,” then the counter-parties will be able to liquidate their positions without first obtaining relief from the automatic stay.
- Securitization and Participation Agreements and Swap Agreements. Investors in Lehman sponsored securitizations and participation agreements may also be affected by the bankruptcy filing. However, under Section 560 of the Bankruptcy Code, the automatic stay does not apply to the enforcement of contractual rights under swap agreements. Under most Lehman ISDA Agreements, LBHI is specified as “Credit Support Provider” for LBIE and LBSF.1 What does this mean? The filing by LBHI as Credit Support Provider constitutes an Event of Default with respect to LBIE and LBSF under Section 5(a)(vii)(4) of their ISDA Agreements, effective immediately and gives a right, but not an obligation, of the non-Lehman party to cause the early termination of all (but not less than all) outstanding Transactions under such party’s ISDA Agreement with either LBIE or LBSF. In order to effect an early termination, the non-Lehman party must send a notice of default, which generally may not be delivered by email or facsimile, specifying the relevant Event of Default and designating an Early Termination Date with respect to all outstanding Transactions. The Early Termination Date cannot be earlier than the day the notice is delivered and cannot be later than 20 days thereafter. If an ISDA Agreement specifies “Automatic Early Termination” as applicable, the Early Termination Date will occur immediately upon the occurrence of the relevant Event of Default without the need to send a notice.
Following the occurrence and during the continuation of an Event of Default under both the 1992 and 2002 ISDA Agreements, but prior to the designation of an Early Termination Date, the non-Lehman party may:
- suspend performance of any obligation to make a payment or delivery under any Transaction;
- withhold the transfer of additional Eligible Credit Support and return of any collateral posted by the Defaulting Party; and
- as typically provided, demand the transfer of collateral held by the Defaulting Party to a Custodian that satisfies any specified eligibility criteria.
Generally, the non-Lehman party may also demand the return of any collateral posted by it with the Defaulting Party following the designation of an Early Termination Date. To the extent such collateral is not returned, the specified non-Lehman counterparty may setoff any amounts payable by it under the ISDA Agreement against any Posted Collateral held by the specific Lehman Defaulting Party.
As soon as reasonably practicable following the occurrence of an Early Termination Date, the non-Lehman party must calculate and provide the other party with a statement of the amount payable as a result of the early termination. This amount is payable, together with any interest, on the day on which notice of the amount payable is effective and is calculated in accordance with the relevant provisions of the 1992 or 2002 ISDA Agreement, as applicable.
ISDA 1992 Master Agreement. The Settlement Amount payable under a 1992 ISDA Master Agreement is calculated pursuant to one of two methods, as elected by the parties in the Schedule: “Market Quotation” or “Loss” (Market Quotation being the default if no method is specified). If the parties elected Market Quotation, the non- Lehman party (or its agent) will solicit quotations from four Reference Market-makers for the replacement value of each Terminated Transaction or group of Transactions. Market quotations should be requested to the extent reasonably practicable as of the same day and time on or as soon as reasonably practicable after the relevant Early Termination Date. If the party cannot obtain at least three quotations, it will be deemed that Market Quotation cannot be determined. If Market Quotation cannot be determined or would not produce a commercially reasonable result (in the reasonable belief of the party making the determination), the ISDA Agreement defaults to Loss.
It can be expected that the sheer volume of terminated transactions and the need to obtain market quotations by numerous market participants will cause serious delays in obtaining these quotations. The 1992 ISDA Agreement provides for some flexibility to address concerns about a party’s ability to obtain quotations and about the effect on market prices of massive requests on a single day for quotations for replacement transactions, namely in connection with the bankruptcy of a major market participant like LBHI. Under the 1992 ISDA Agreement, as long as quotations are requested “as of” the same time and day, a party may seek quotations over a period of days or even weeks following the Early Termination Date. If the parties elected Loss, the non-Lehman party may determine the Settlement Amount based on information from internal sources as well as quotations, if desired, and may include losses or costs incurred as a result of the termination, liquidation or re-establishing hedging transactions with third parties.
ISDA 2002 Master Agreement. Under the ISDA 2002 Master Agreement, the non-Lehman party determines the Close-out Amount on the basis of the losses or gains that would be realized in replacing or providing the economic equivalent of the Terminated Transactions and option rights in respect to such Terminated Transactions. The Determining Party may use any relevant information, including information from internal sources, third-party market data and market quotations to calculate the Close-out Amount.
Clearly, as illustrated in this memorandum, the largest ever bankruptcy filing will present complex and challenging business and legal issues in the coming months and we will continue to update clients as the story unfolds.