Lehman Shows Trans-Atlantic Divide on Derivatives

Lehman Shows Trans-Atlantic Divide on Derivatives

By STEPHEN J. LUBBEN

Hazel Thompson for The New York Times
Christie’s employees carry items from Lehman’s London headquarters into the auction house in September.The Lehman Brothers bankruptcy case underscores that while the International Swaps and Derivatives Association, the derivatives industry trade group, provides a single master agreement for use in derivatives trades in the important New York and London markets, the interpretation of that agreement can vary greatly across those two jurisdictions.

While Britain provided the basis for the American legal system, the reality is that derivatives trade group’s one master agreement is being subjected to two fairly different bankruptcy systems.

Start with the basics: Throughout the world, derivatives transactions are usually documented with two main parts. First, the parties enter into a master agreement, which provides basic terms for all trades between those parties.

For example, a hedge fund that wants to conduct a series of derivatives trades with Goldman Sachs will enter into a master agreement with Goldman, or, more realistically, a Goldman subsidiary, although the Goldman parent company might be a guarantor and in most cases will be a “credit support provider” under the master agreement.

Second, the parties will enter into “schedules” that document each individual class of derivatives trade conducted under that master agreement. These schedules document the financial terms of the deal, and often also invoke special rules that the derivatives trade group has formulated for specific transactions. For example, credit default swaps have their own set of rules.

In the Lehman case, we’ve already seen two issues decided in conflicting fashion in London and New York, although to be fair the first did not directly involve the derivatives trade group’s documents. This was the issue concerning “flip” clauses, provisions in derivatives that purport to “flip” the parties’ priority rights in collateral if the senior party files for bankruptcy.

The New York Bankruptcy Court held that such a clause violated the Bankruptcy Code, while courts in Britain upheld the clause as permissible under English law.

Much fuss was made over the fact that the derivatives in question involved an English choice of law clause, but that seems irrelevant to me, given the usual rule that contracts can’t override the Bankruptcy Code. The issue has since been settled.

More recently, the British courts have allowed several Lehman counterparties to exercise what I’ve taken to calling the third option. Normally, when a party to a derivatives contract files for bankruptcy, the debtor’s counterparty has two options: it can waive the default and continue as nothing has happened or it can terminate the deal (or deals, if there are multiple contracts outstanding), with damages based on the current market value of the derivative. In short, default by a party gives rise to an option to terminate, and filing for bankruptcy is an enforceable default in a derivatives contract.

But in the Lehman case, several counterparties have tried to create a third option, whereby they cease performing their obligations under the contract but also refuse to terminate the contract. Termination is unattractive because in most of these cases Lehman is the “in the money” party to the deal.

For example, if a party bought an interest rate swap from Lehman – in other words, agreed to pay Lehman a fixed rate while Lehman paid a floating rate — to hedge against rising interest rates, Lehman is owed money under the contract since interest rates have, in fact, fallen. Termination of the swap would require a large payment into Lehman’s bankruptcy estate.

Seizing on language in the 2002 version of the master agreement that makes performance contingent on there being no outstanding defaults on the derivatives contract, these counterparties have simply left their contracts in limbo. Plainly the hope is to allow the contracts to expire by their own terms without ever invoking the termination procedure, and the obligation to contribute to Lehman’s bankruptcy estate. In short, the counterparties are trying to run out the clock under this third option. From Lehman’s perspective this looks a lot like an effort to destroy a valuable asset of the bankruptcy estate.

The crucial question is whether this third option was ever intended by the drafters of the derivatives trade group’s 2002 master agreement. The International Swaps and Derivatives Association argued in London in favor of the third option, but I think that its actions have to be somewhat discounted, given its general hostility to the normal operation of reorganization systems like Chapter 11.

A more reasonable interpretation of the 2002 master agreement would seem to be that a default is waived if not acted upon within a reasonable time. This is essentially the result reached by the Federal Bankruptcy Court in Manhattan, and avoids the problems that might result if a nonbankrupt counterparty were able to exercise the third option until such time as interest rates rise.

In short, a nonbankrupt party should not be able to convert the swap into an option on interest rates, where they only perform when it hurts the bankruptcy estate.

Nonetheless, for the time being such an option exists in London, but not in New York, even though derivatives traded in these jurisdictions are documented under the same contracts.


--------------------------------------------------------------------------------


Stephen J. Lubben is the Daniel J. Moore Professor of Law at Seton Hall Law School and an expert on bankruptcy.