News Analysis

Close-out conundrum

Wednesday 25 March 2009 00:00 London/ 19.00 (- 1 day) New York/ 08.00 Tokyo

Court action provides some clarity for derivatives documentation

The inability of the Lehman Brothers bankruptcy estate to access the value of in-the-money swaps in Lehman's favour has raised documentation concerns. Subsequent actions by the US bankruptcy court are nonetheless expected to influence how counterparties handle close-outs in future bankruptcies.

The Lehman estate took the position that, as its counterparties weren't exercising their termination rights under section 2(a)(iii) of the 1992 and 2002 ISDA Master Agreements, they had live contracts and so decided to assign them under the US bankruptcy code. Because the position is in-the-money for Lehman it has value for the new counterparty, so they would be prepared to pay for the assignment.

But this meant that the original counterparties were facing an unknown new counterparty, albeit one with minimum standards of creditworthiness as decided by the court. Consequently, the original counterparties were forced to decide whether they really wanted to keep the trade after all and a substantial number closed out, willing to take the risk of the market reimbursing them with the mark-to-market value rather than facing an unknown counterparty.

This assignment and assumption process is likely to influence how counterparties handle close-outs in future bankruptcies, according to Joshua Cohn, partner at Allen & Overy in New York. "The court has provided helpful clarifications in demonstrating its assignment powers and in terms of expressly leaving the option open to parties to close out rather than risk assignment," he explains.

He continues: "One could argue that case law under the bankruptcy code states that one can only use the safe-harbour right to terminate derivatives contracts, if one does so promptly. But the court allowed counterparties to close out even though it was months after the bankruptcy filing: it has essentially given a fair warning that if a counterparty stands behind section 2(a)(iii), they may be assigned or they may be unable to close out. This flexible outcome regarding close out may never happen again, so a counterparty should treat their rights under section 2(a)(iii) gingerly."

But some contracts weren't easily reassigned (because, for example, they were significantly off-market or no alternative counterparties were interested), so a pool of open transactions remains. Cohn says that this points to the question of how the US bankruptcy court will ultimately treat the stalemate issue under section 2(a)(iii) and whether it finds a way of accessing the value of those contracts.

Under the terms of the contracts, the Lehman companies usually can't assign the contract without the consent of the original counterparties, so they need a court order to allow the transfer (essentially overriding the contractual agreement for those counterparties that don't provide their consent). A hearing is scheduled for 3 June, but - given that the hearing has previously been postponed several times - there is some doubt as to when it will actually go ahead.

Jeremy Jennings-Mares, capital markets partner at Morrison & Foerster, notes that - if the hearing takes place and a judgement is given in favour of the Lehman companies - one interesting question is how the decision under New York law will relate to contracts governed by English law. "There is significant doubt as to whether the judgement will be recognised in the English courts, given the number of tricky conflicts of law issues involved. Certainly the market needs further details about how the proposal will work and so the hearing should help to clarify the situation."

An associated concern for the market is in connection with the risk of levy of default interest for those positions that are closed out late.

The case of Enron Australia versus TXU Electricity [2003] NSWSC 1169 (24 December 2003) was the first where a non-defaulting party in a derivatives contract used the insolvency of the other party as an excuse not to make payment under section 2(a)(iii). TXU had a net mark-to-market liability to Enron under 78 contracts of approximately A$3.3m, but the court recognised TXU's ability to rely on the flawed asset provision of section 2(a)(iii) to avoid having to make payment to Enron and the company was not obliged to close-out the ISDA Agreement.

In a client note about the case, Allens Arthur Robinson advises lenders to incorporate in their inter-creditor arrangements with hedge banks, or other relevant counterparties, provisions to restrict them from limiting the assets of the borrower available to be distributed to creditors or the cashflow available in security enforcement. However, the law firm notes that negotiating changes to existing and future ISDA Agreements may be difficult, as "counterparties will want to preserve their options".

Peter Green, capital markets partner at Morrison & Foerster, suggests that among the major lessons to learn from the Lehman bankruptcy are to keep track of posted collateral, ensure that the return of any excess is requested and consider carefully the legal framework of the jurisdictions where a counterparty has exposure. "For example, it is important to consider how collateral could become trapped," he says.

Parties are also likely to focus more on the circumstances in which collateral is required to be delivered. "Normally under the collateral arrangements, a counterparty only has to post collateral if their exposure goes beyond a threshold amount that is set at a reasonably high level, depending on the creditworthiness of the counterparty. Now, the level of the threshold amount may have to be reduced; for instance, it is likely to become more common to see provisions whereby the threshold amount will be reduced or removed if a counterparty's rating falls below a certain level," Green concludes.

25/03/2009