On January 25, 2010, United States Bankruptcy Court Judge James M. Peck issued a decision that limited the ability of parties to swap transactions to enforce certain of their contractual rights against a counterparty that has filed for bankruptcy. See Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd.1 (the “BNY Decision”). Because it narrowed the scope of the Bankruptcy Code’s safe harbor provisions, which protect a non-defaulting swap participant’s contractual rights to “liquidate, terminate or accelerate” a swap agreement, the BNY Decision upset important expectations of many participants in the derivatives markets and has been the subject of much market and legal criticism.  

Relying on the BNY Decision, Lehman, in a little noticed proceeding, now seeks to further narrow the scope of the safe harbor provisions. In a dispute with a swap counterparty over the value of a terminated swap, Lehman has argued that Lehman has the right to determine the close-out amount of the swap, even though Lehman was the defaulting party.

Justifiably concerned that Judge Peck will rely on his BNY Decision and rule in Lehman’s favor, the non-defaulting counterparty—the Michigan State Housing Development Authority (“MSHDA”)— has asked a federal district court judge to take the case away from the Bankruptcy Court. If the District Court grants MSHDA’s request and accepts this case, its ultimate decision on the scope of the safe harbor in protecting the rights of non-defaulting parties could have significant consequences for the derivatives market. Any decision could have an immediate practical effect on the Lehman bankruptcy proceedings, where many of Lehman’s former swap counterparties are litigating or negotiating with Lehman under the cloud of the BNY Decision.  

MSHDA-LEHMAN SWAP AGREEMENT  

MSHDA had a series of interest rate swaps with Lehman Brothers Special Financing Inc. (“LBSF”). The swaps were governed by an International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement (“Master Agreement”), but the agreement contained modifications to the standard terms. Typically, the Master Agreement provides that where one party defaults, the non-defaulting party has the right to terminate the swap and then calculate the amount owed as a result of the early termination, referred to as the “Settlement Amount.” Under the calculation method that most parties elect, the non-defaulting party calculates the Settlement Amount by obtaining a “Market Quotation” that reflects the amount the non-defaulting party would be paid (or would pay) to enter into a replacement transaction based on third party quotations. Where a Market Quotation cannot be obtained, the non-defaulting party calculates its own loss (or gain).

In contrast to the standard swap form agreement, the MSHDA-LBSF swap agreement provided that if LBSF defaulted, LBSF (and not MSHDA) would calculate the Settlement Amount using a “mid market methodology” unless the default resulted from LBSF failing to pay an amount owed or LBSF’s filing for bankruptcy. In the latter two situations, the agreement provided that MSHDA would calculate the Settlement Amount and that it would use the Market Quotation provisions discussed above.  

On November 5, 2008, a few weeks after LBSF filed for bankruptcy, MSHDA terminated the swap transactions on account of LBSF’s bankruptcy-based default. According to MSHDA, it calculated the Settlement Amount using the Market Quotation provisions, as provided in the swap agreement with LBSF. Because the swaps were “out-of-the-money” from MSHDA’s perspective, MSHDA paid LBSF that amount.  

Now, relying on the BNY Decision, LBSF has argued in the Bankruptcy Court that the provision of the agreement that permits MSHDA to calculate the Settlement Amount is unenforceable. LBSF contends that the “method by which the Settlement Amount is calculated upon termination . . . is ancillary to” the right to terminate, liquidate or accelerate the swap agreement and “therefore it is not protected by the statutory safe harbor under Section 560 of the Bankruptcy Code.”2 Thus, LBSF argues that it has the sole right to calculate the Settlement Amount using a “mid market methodology” that would entitle LBSF to $23 million plus interest.

THE BNY DECISION

In the BNY Decision, the Court held that, among other things, a “flip” clause—a provision that shifted payment priority away from a swap counterparty when that counterparty defaulted—was unenforceable when the default was caused by a bankruptcy filing. The Bankruptcy Code specifically invalidates contractual clauses (referred to as “ipso facto” clauses) that terminate or modify a party’s rights on account of its bankruptcy filing, and the Bankruptcy Court held that the “flip” clause in the BNY case constituted an unenforceable ipso facto clause.  

BNY Corporate Trustee Services Ltd. (“BNY”) had argued that the flip clause was not an ipso facto clause, and that even if the flip clause provision constituted an otherwise unenforceable ipso facto clause, the provision was enforceable under the Bankruptcy Code’s safe harbor provisions for swap agreements and other financial contracts, which protect a non-defaulting swap participant’s contractual right to “liquidate, terminate or accelerate” a swap agreement. BNY contended that the flip provisions were part of the overall contractual arrangement pursuant to which the parties agreed to liquidate their transactions and thus were protected by the safe harbor provisions.  

In rejecting BNY’s argument, the Bankruptcy Court held that although the safe harbor deals with the “liquidation, termination or acceleration” of swap agreements, it does not extend to contractual provisions in a swap agreement that alter the parties’ rights to payment.

MSHDA’S MOTION TO THE DISTRICT COURT  

In asking the District Court to withdraw the case from the Bankruptcy Court, MSHDA contends that its dispute with Lehman revolves around one of the very issues Judge Peck decided in the BNY Decision, and MSHDA has asked that the District Court take the pending MSHDA case so that the BNY Decision can effectively be reviewed.

Specifically, MSHDA, making arguments previously made by ISDA, argues that the BNY Decision was based on an “overly narrow construction of the Bankruptcy Code’s derivative safe-harbor provisions . . . [and] threaten[s] the sound functioning of the derivatives market.”3 MSHDA argues that the scope of the safe harbor should be considered by the District Court now, rather than on appeal of a decision by the Bankruptcy Court, in order to provide the derivatives market with the certainty it now lacks. MSHDA has advised the District Court that it intends to advance the argument put forward by both ISDA and the Securities Industry and Financial Markets Association that “the safe harbor provisions . . . exempt from ‘ipso facto’ challenge contractual agreements addressing the calculation and payment of amounts due in connection with a terminated swap agreement.”4

The District Court must now decide whether the narrow reading of the safe harbor set out in the BNY Decision should be reviewed, and, if it is reviewed, whether it should stand. A decision by the District Court could send an important signal to creditors holding swap claims in the Lehman proceedings.