Global swaps markets still in limbo after Lehman settlement Bryan Frith From: The Australian

Global swaps markets still in limbo after Lehman settlement Bryan Frith From: The Australian November 30, 2010 12:00AM

THE collapsed Lehman Brothers has secured a major tactical victory by agreeing to a commercial settlement with Perpetual Trustees.
This will prolong the massive uncertainty in the $US426 trillion global swaps market.

In a controversial decision earlier this year, US bankruptcy judge James Peck effectively overturned the basis on which the derivative markets work.

The International Swaps and Derivatives Association (ISDA) claimed that the "narrow readings" of the safe harbour provisions threatened to undermine the protections that Congress intended to provide the derivatives markets and that if the ruling were to stand it would result in a "fundamental upheaval" of the market.

In allowing an appeal against the ruling, Judge Colleen McMahon of the US District Court said that Lehman for months had sought to forestall review of the decision and used the delay "as leverage in settlement negotiations to recover billions of dollars from various other structured finance deals that would otherwise have been distributed to noteholders".



Peck acknowledged that his interpretation of the US bankruptcy laws was unprecedented.

In allowing an appeal against the ruling, McMahon referred to Peck's "novel statutory interpretation to the circumstances at hand".

The settlement with Perpetual will create further uncertainty in the derivatives market and give Lehman more time to try to persuade other parties involved in similar transactions with the failed investment banker to settle claims.

The settlement with Perpetual relates to $US125 million invested in synthetic debt instruments -- credit-linked notes -- which are held for more than 1000 investors, including individuals, councils and charities in Australia, New Zealand and PNG. That amount is significant to the investors involved but is peanuts in the context of the global markets for such synthetic instruments.

The notes were issued by an Australian company Mahogany Capital, which is listed on the ASX but has been suspended from trading for more than two years. The company was placed in administration last December and liquidators were appointed in July.

Perpetual is the trustee for the Mahogany noteholders.

Lehman has applied for a 90 day stay of appeal against the Peck ruling to allow it to finalise the settlement with Perpetual. Lehman said in papers filed with the court that the settlement would result in a "substantial payment" to the estate of Lehman Brothers Special Financing (LBSF).

How substantial is not known because the details of the settlement are confidential and have been excluded from documents filed with the court. Observers suggest that Lehman does not want the market to know the details, in order to maintain uncertainty and thereby strengthen its hand in negotiations to obtain more significant settlements.

Perpetual has not said anything publicly, not even to confirm the settlement in principle.

Mahogany, although suspended, has obligations to maintain an informed market, but the liquidators have not been provided with any information about the proposed deal.

What seems clear is that any funds that go to Lehman under the settlement will decrease the amount which would otherwise become available for the Mahogany noteholders.

Perpetual's decision to settle was a surprise, as many in US legal circles expected that the appeal would be upheld and Peck's ruling would be overturned.

Perpetual is expected to write to Mahogany noteholders within the next two weeks, but whether it will disclose the settlement terms, including the amount in the dollar that noteholders can expect to receive, is unclear.

However, it's difficult to see how it can remain secret forever, as at some stages payments will need to be made to the noteholders.

The proposed settlement raises the question as to whether Perpetual should seek the approval of the noteholders. It's possible that some noteholders would prefer to continue with the appeal and take their chances on a higher payout.

However, the documents filed in the US court state that the settlement will be subject to Perpetual obtaining judicial advice from the Australian court that entry into, and performance of, the settlement is a proper exercise of Perpetual's powers and duties as a trustee.

That presumably is to remove or limit any question of potential liability. It could also be seen as an indication that Perpetual is not intending to seek noteholder approval.

At issue is the collateral that backs the CDOs and which is held by BNY Corporate Trustee Services (BNYT), a British incorporated trustee that is part of the Bank of New York Mellon. The collateral -- medium-term notes issued by ANZ and RBS banks -- is to secure obligations under a credit swap default agreement with LBSF a Lehman Bros subsidiary. The obligations of LBSF under the swap agreement were guaranteed by Lehman.

Mahogany, a special purpose company owned by Perpetual, used the proceeds of the note issue to purchase credit-linked notes in Sapir Finance, a special purpose company formed in Ireland and the source of the funds for paying the interest and principal on the Mahogany notes.

Saphir, in turn, used the proceeds from its note issue to purchase collateral in the form of bank-issued medium-term notes, to secure its obligations under a credit default swap agreement with LBSF.

Lehman went into US Chapter 11 bankruptcy in September 2008 and LBF followed suit a month later. Since then Lehman and Perpetual have been in dispute as to who has priority in relation to the collateral.

The trust deed, which is governed by English law, provides that the proceeds from the collateral first should be applied towards amounts owing to Lehman under the swap and second to the Mahogany investors, But if Lehman defaulted, the noteholders would rank ahead of the Lehman.
That's known as the principle of "bankruptcy remoteness" and it's industry standard. It's vital to securitisation because it enables CDOs to be highly rated by the credit agencies even though the originator may have a much lower rating. If the originator had priority in a bankruptcy it would completely undermine the multi-trillion securitisation market.

Litigation over the notes has resulted in a cross-jurisdictional hiatus. The High Court of England has ruled that under English law the noteholders have priority over Lehman, but that was countered by Peck's ruling that the "flip" clause, which gave the noteholders priority, violated US bankruptcy laws.

The British Supreme Court has agreed to hear an appeal by LBSF against the High Court ruling, but it would be surprising if it overturned that ruling.

So the jurisdictional hiatus may remain for some time, which would work in the favour of Lehman.

bfrith@acenet.com.au