Many clients have asked us for guidance as to the basic mechanics of dealing with the Lehman bankruptcy. Although this list is not exhaustive, we have set forth below some of the issues that you may want to think about. (This guidance is with respect to transactions entered into under the 1992 ISDA Master Agreement, and capitalized terms used herein are defined in that agreement. Note that while most of the considerations would also be relevant to transactions documented under the 2002 ISDA Master Agreement, the terms of that agreement vary from the 1992 Agreement and should be analyzed separately.*)
First, locate each Master Agreement with a Lehman entity. You need to confirm whether the Lehman entity which is your counterparty or a Credit Support Provider for that Lehman entity has filed for bankruptcy. To date, we understand that the only Lehman entity which has made a bankruptcy filing is Lehman Brothers Holdings Inc. If Lehman Brothers Holdings Inc. is a Credit Support Provider under your agreement, then an Event of Default has occurred even though the specific Lehman entity which is your counterparty has not filed for bankruptcy. If your counterparty is not Lehman Brothers Holdings Inc. and that entity is not a Credit Support Provider, you will need to look to other provisions of your agreement to determine whether an Event of Default or other Termination Event has occurred. (Note: Even if your agreement is not in default on account of the bankruptcy filing, ratings downgrades are likely to occur and should be monitored regarding the right to early terminate. Similarly, the failure of your Lehman counterparty to make a payment or transfer collateral in accordance with the terms of your Credit Support Agreement (“CSA”) would also give rise to an Event of Default.)
If an Event of Default has occurred, you are probably not required to make any further transaction payments or to transfer collateral under the CSA (whether or not you file a notice of default). Your Lehman counterparty is still obligated to make transaction payments to you and you may still request Lehman to post collateral to you. Review your Master Agreement to determine whether Lehman remains eligible to act as Calculation Agent and, if not, whether you can so act or must appoint a third party. Similarly, review the terms of your CSA to determine whether you are in a position to act as Valuation Agent and request additional collateral or the return of Posted Collateral which Lehman is currently holding.
Evaluate the net open positions under your Master Agreement. (If you have multiple entities that each have their own Master Agreement with Lehman, the trades under each separate agreement must be analyzed separately.) (Note that if the agreement relates to several types of products, CDS, interest rate, FX, commodities, netting on closeout may occur in separate baskets, depending on the terms of your agreement.) The Non-defaulting Party does not have to designate an Early Termination Date. If with respect to outstanding trades under a particular agreement you are net “out-of-the-money” and do not want to make a payment to Lehman at this time, you may want to defer designating an Early Termination Date. Keep in mind, however, you may not cherry pick transactions - the agreement and all related transactions must be terminated.
If Automatic Early Termination (“AET”) for Bankruptcy has been designated, the agreement terminates as of the date of the bankruptcy filing. If AET is not specified as applying, or another credit-based Event of Default or Termination Event has occurred (e.g., due to a ratings downgrade Additional Termination Event), the Non-defaulting/Non-affected Party must specify as an Early Termination Date any date from the date the notice of early termination is effective until 20 days thereafter. The Non-defaulting Party must also prepare forms of early termination notice, verify methods of delivery (i.e., fax is likely not effective delivery) and the effective date of notice.
Selection of the precise Early Termination Date that you designated may take into account a number of factors including market volatility for the transactions being terminated, the anticipated ability to obtain market quotes for terminated transactions in the days immediately following the bankruptcy filing, analysis of your collateral holdings or postings and the volatility of valuations of such collateral, and an assessment of your ability to enter into replacement transactions to preserve hedges or proprietary positions.
If your Master Agreement specifies Market Quotation, the Non-defaulting Party, as the determining party is obligated to request market quotes from reference market-makers. The request for quotes should be made "promptly" after the Early Termination Date and should specify the date and time "as of" when the quote is requested. Market quotes are for replacement transactions - the price at which the reference maker would be willing to step into a replacement transaction.
The ISDA Agreement specifies that if the Non-defaulting Party makes reasonable attempts to get market quotes and cannot obtain at least three quotes from reference market-makers, the Non-defaulting Party has a right to revert to a "Loss" calculation. In the current market environment, it is difficult to know what will constitute a “reasonable effort” to obtain quotations from reference market-makers, but it is important to keep careful records of the attempts that are made.
The Loss calculation is, generally speaking, an amount that the Non-defaulting Party reasonably determines in good faith to be its total losses and costs with respect to the terminated transaction, including any loss of bargain, cost of finding or the loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge or related trading position. The Loss calculation may (but need not) be determined by reference to quotations from one or more leading dealers in the relevant market.
The Non-defaulting/Non-affected Party must be able to show, in reasonable detail, how the quotes were obtained or how the Loss calculations were made.
Without regard to whether you elect to designate an Early Termination Date, under the Credit Support Annex the Non-defaulting Party may request that Lehman move collateral to a segregated account with an unaffiliated custodian. In addition, parties should carefully examine the provisions of their CSA pertaining to rehypothecation of Posted Collateral to determine whether Lehman continues to be eligible to rehypothecate. Once an Event of Default has occurred and an Early Termination Date has been designated, it is clear that the defaulting party would no longer be entitled to rehypothecate Posted Collateral. (It is less clear whether the mere occurrence of an Event of Default, without the designation of an Early Termination Date, results in suspension of rehypothecation rights.)
Posted Collateral which has been rehypothecated may not be immediately available to be segregated, but any collateral that remains with Lehman could be better protected in a segregated account. There is at least a risk that a bankruptcy court could treat the excess collateral as property of the bankruptcy estate and potentially could grant the Non-defaulting Party an unsecured claim with respect to any excess collateral.
The foregoing is provided for your general information. Any specific actions to be taken in this matter should be based on a thorough review of the applicable agreements because those agreements could well modify the general observations provided above.