Those active in the derivatives market may be familiar with the Bankruptcy Code’s “safe harbor” provisions. These provisions are intended to protect derivatives participants from some of the debtor-friendly effects of bankruptcy, all in the name of ensuring market stability if a large derivatives market firm were to fail. The safe harbor provisions have been put to the test in the Lehman bankruptcy cases, with several market-affecting decisions issued over the last four years. Last week, the bankruptcy court issued another important decision addressing the safe harbors. See Michigan State Housing Development Authority v. Lehman Brothers Derivative Prods. Inc., et al. (In re Lehman Brothers Holdings Inc.), Adv. No. 09-01728 (Bankr. S.D.N.Y. Dec. 19, 2013). This decision, unlike earlier ones, may be the cause of some celebration for market participants.

A big issue for Lehman and its derivatives counterparties has been the scope of the safe harbors. Lehman has argued successfully in the past that the safe harbor provisions should be construed narrowly to protect only a limited number and type of contractual rights. In last week’s decision, the bankruptcy court sided with the counterparty, reading the safe harbors to protect the counterparty’s calculation of amounts owing in connection with its liquidation of its swap with Lehman.

Recap of Relevant Bankruptcy Code Sections

The Bankruptcy Code includes various protections to debtors, with the goal of helping them reorganize if possible or, if not, to liquidate in an orderly fashion. As noted in our last posting, upon the bankruptcy filing an “automatic stay” arises, halting creditors’ collection activity.

In addition to the automatic stay, the Bankruptcy Code expressly prohibits counterparties from terminating or modifying their contracts with a debtor, when such termination or modification is based solely on the debtor’s bankruptcy filing. Many contracts will provide that if a party files for bankruptcy, the bankruptcy filing is an event of default that permits the other counterparty to terminate the contract. Bankruptcy Code section 365(e)(1) invalidates these “ipso facto” contractual provisions, so that the debtor does not lose valuable contracts it may need in connection with its reorganization efforts.

The safe harbor provisions protect counterparties to derivatives contracts (e.g., swaps, forward contracts, and repos), permitting counterparties to enforce their contractual rights to liquidate, terminate or accelerate such contracts when such right is triggered on a bankruptcy filing or the debtor’s financial condition. Not only do these contract provisions remain valid (notwithstanding Bankruptcy Code section 365(e)(1)), counterparties are free to exercise these rights without first obtaining relief from the stay.

Relevant Case Facts and Swap Provision under Attack

Michigan State Housing Development Authority (Housing) was party to an interest rate swap with Lehman Brothers Special Financing Inc. (LBSF) before it filed for bankruptcy. The swap contained a liquidation paragraph, which provided in relevant part that:

calculation of the Settlement Amount of the swap upon termination would be performed using the “Mid-Market” method. However, if termination was a result of the bankruptcy of LBSF, then “Market Quotation” method would instead be used to calculate the Settlement Amount.

When LBSF filed for bankruptcy, Housing terminated the swap and, according to the liquidation provision, used the Market Quotation method to calculate (and then pay) LBSF the Settlement Amount owing.

The Arguments Made

Lehman argued that the swap’s liquidation provision, switching the calculation method from Mid-Market to Market Quotation solely based on LBSF’s bankruptcy filing, was an ipso facto provision invalidated by Bankruptcy Code section 365(e)(1). Lehman’s motivation for making such argument? If Housing had calculated the Settlement Amount using the Mid-Market method instead of Market Quotation, Housing would have owed Lehman approximately $23 million more. Lehman argued that only a counterparty’s acts, and not its related rights, are protected by the safe harbors. Accordingly, while the safe harbor permitted Housing to liquidate the swap, Lehman asserted that how to calculate the amount due in connection with such liquidation was not similarly protected.

Housing, on the other hand, argued that use of the calculation method provided for in the liquidation provision was clearly protected by Bankruptcy Code section 560’s safe harbor as an integral part of the act of liquidating the swap.

The Bankruptcy Court’s Ruling

The bankruptcy court agreed with Housing. In rejecting Lehman’s more narrow interpretation of the safe harbor, the court made three points:

1. Proper weight must be given to the safe harbor’s protection of “the exercise of any contractual right” to cause the liquidation of a swap. The court noted that “[u]nless the act of liquidation is performed in accordance with some agreed method, the right to liquidate is disconnected and loses all practical meaning.”
2. The determination of whether a liquidation calculation method is protected by the safe harbors is not decided by whether the method produces more or less value for the debtor. Both Market Quotation method and Mid-Market method were contractually approved valuation methods, and LBSF failed to explain why it should be released from its prepetition agreement to use “a commercially acceptable method chosen by the parties themselves” in the event of its bankruptcy filing.
3. Allowing Housing, the non-debtor counterparty, to use the liquidation method contractually agreed with LBSF “promotes the goals of the safe harbor – to provide stability and certainty to the markets upon the insolvency of a counterparty and to enable the parties themselves to liquidate collateral in a contractually prescribed manner.”

Many are familiar with the bankruptcy court’s earlier “Dante” decision, in which the bankruptcy court, siding with Lehman, held that a “flip clause” (which reordered the payment priorities in a collateralized debt obligation (CDO) transaction) was an unenforceable ipso facto provision that fell outside the scope of the safe harbors’ protections. The bankruptcy court distinguished the Dante decision from the one here, noting first its finding in Dante that the flip clause had been included in a supplemental agreement and was not part of the actual swap agreement. Second, the bankruptcy court asserted that Dante addressed a provision altering priority of payment and (unlike in the Housing case) not a provision strictly dealing with liquidation, termination, or acceleration. This “distinction” may not be as apparent as the court suggests, as both the Dante and Housing provisions were relevant in determining what was owed, if anything, to Lehman in connection with the swap’s termination. However, the bankruptcy court seems to establish a spectrum on which provisions will be considered for safe harbor protection:

“[“Ancillary” and “incidental”] are descriptive words that tend to distance a particular act from [the protected zone of the safe harbors], and the greater the distance, the more attenuated the ability to claim any immunity from the ipso facto bar to enforceability.”

Take-Aways

The Housing decision will be useful to counterparties still working with Lehman to calculate what is owed on now terminated derivatives contracts between the parties. The decision also gives some comfort to the derivatives market, as the bankruptcy court surely intended, allowing market participants more certainty in how they value their derivatives. This certainty has its limits with the Dante decision still valid, and counterparties will need to consider whether their contract provisions are more like the provisions discussed in Dante or the provisions discussed in Housing.