On November 13, 2008, Lehman Brothers Holdings Inc. and its affiliated debtors in Chapter 11 (collectively, “Lehman”) filed a motion (the “Motion”) seeking Bankruptcy Court approval of procedures (the “Procedures”) for the assumption and assignment of derivative contracts not yet terminated by its various counterparties, as well confirmation of Lehman’s right to enter into settlement agreements for the termination of derivative contracts that have been terminated by its counterparties post-petition.
Lehman estimates that, as of the date of the Motion, it is party to approximately 930,000 derivative transactions, of which about 733,000 have been terminated post-petition. Among the contracts that have not been terminated according to the Motion are transactions that are “in the money” to Lehman and that constitute significant assets of Lehman’s estates.
Unless counterparties elect to terminate open transactions—which is rather unlikely in the case where Lehman is “in the money” as this would probably trigger an immediate net payment obligation to Lehman by such counterparties—Lehman may not be able to monetize these contracts until they are terminated or expire on their own terms. During that period, Lehman may not be able to preserve the value of these transactions because the transactions may lose all or part of their value as a result of movements in the financial markets over such period. This, in turn, may affect the value available to Lehman’s estates in the various Chapter 11 cases.
Accordingly, Lehman would like to assume and assign some or all of its “in the money” derivative contracts to third parties in exchange for consideration, thereby realizing the value of such derivative contracts for the estates. Because most contracts require the counterparty’s consent to assignment, Lehman seeks to be able to assign the derivative contracts over the objection of the counterparty, in accordance with the Bankruptcy Code, if it satisfies the requirements set forth in section 365 of the Bankruptcy Code. The Procedures are intended to address these requirements.
In addition, the Procedures seek to confirm Lehman’s authority to enter into settlement agreements with counterparties that have terminated their derivative contracts with Lehman, pursuant to which the parties may resolve and fix amounts owing between them, permit the collateral or margin held by its counterparties to be liquidated or returned in accordance with the derivative transactions, and provide releases to the counterparties if Lehman determines such releases to be appropriate. These termination and settlement procedures may also apply where Lehman seeks to reach mutually agreed-upon termination amounts with counterparties who have not yet terminated, but may be willing to do so.
The following is a summary of the Procedures:
(a) Assumption and Assignment Procedures
(1) Single Agreement – In instances where multiple derivative transactions are governed by a single master agreement, each master agreement will be treated as one single derivative contract.
(2) Notice – Lehman will provide five days prior notice to the applicable counterparty in respect of each derivative contract to be assumed and assigned. Each notice will identify the underlying derivative contract and will contain (i) the identity of any proposed assignee (and credit support provider) or a statement that the assignee (and credit support provider) will have a certain minimum credit rating (at least A- (Standard & Poor’s or Fitch) or A3 (Moody’s)) (a “Qualified Assignee”) and (ii) the amount proposed to be paid by Lehman to cure existing defaults (“Cure Amount”).
(3) Adequate assurance of future performance – The adequate assurance of future performance test under the Bankruptcy Code will be deemed to be satisfied if (i) an assignee or its credit support provider is a Qualified Assignee; or (ii) Lehman, after payment of any Cure Amount, would no longer have any payment or delivery obligations.
(4) Collateral – If a return of collateral is required, Lehman will either return such collateral or will pay an amount equal to the value of such collateral as of the business day prior to service of the assignment notice.
(5) Right to Object – Counterparties who wish to object to the assumption and assignment of any derivative contracts because of (i) the proposed Cure Amount, (ii) the need to cure a default or early termination event or (iii) the lack of adequate assurance of future performance (where neither the assignee nor its credit support provider is a Qualified Assignee), must file a written objection that must specify the grounds for such objection and be received no later than five days after notice of assignment has been served.
(6) Failure to Object – Failure by the counterparty to object timely shall constitute a waiver. The counterparty will be deemed to have consented to assumption and assignment as provided in the assignment notice and in accordance with the Procedures. All then existing defaults under the derivative contract will be deemed to have been cured.
(7) Dispute Resolution – If a counterparty does object and Lehman and the counterparty are unable to reach an agreement with respect to the subject matter of the objection, Lehman may seek authorization from the Bankruptcy Court to consummate the proposed assignment.
(b) Termination and Settlement Procedures
(1) Lehman may enter into and consummate a termination and settlement agreement with any counterparty if so agreed by such counterparty, whether or not such counterparty previously has elected to terminate the derivative contract.
(2) A termination agreement may resolve and fix amounts owing between Lehman and the counterparty.
(3) Lehman may provide a release to the counterparty where Lehman determines such release is appropriate.
(4) A termination agreement may permit the collateral or margin held by Lehman or by the counterparty to be liquidated or returned in accordance with the derivative contract, an applicable master netting agreement, or the termination agreement.
In the Motion, Lehman has stated that it reserves various rights, including the right to (i) dispute the effectiveness of the termination of derivative contracts by counterparties, (ii) challenge whether a derivative contract is entitled to benefit from the safe harbor provisions of the Bankruptcy Code, and (iii) dispute counterparties’ determination to cease performance as a result of the bankruptcy filings or to exercise set-off rights. However, this is not part of the order being sought by Lehman.
If the Motion is granted, “out of the money” counterparties that have not yet exercised their termination right may see their derivative contracts with Lehman novated to a third party. As events of default triggered by Lehman’s bankruptcy filing will be deemed to be cured, such counterparties will effectively lose the right that they may have under their derivative contract to withhold payments thereunder as a result of Lehman’s bankruptcy filing. One strategy that an “out of the money” counterparty might explore would be (i) acquiring “in the money” derivative claims against its Lehman counterparty in an amount equal to the mark-to-market value of its “out of the money” derivative contract, (ii) terminate its derivative contract with Lehman (if termination rights are still available) and (iii) exercise applicable set-off rights so as to net out exposure.
A hearing on the motion has been scheduled for Wednesday December 3, 2008 at 10:00 a.m. Objections are due no later than 4:00 p.m. on Friday, November 28, 2008.