WASHINGTON - In a potentially precedent-setting case that will determine how municipal and other derivatives are treated in bankruptcy proceedings, a federal bankruptcy court in Manhattan is to hold a hearing tomorrow to determine the fate of some 930,000 municipal and other derivatives contracts involving Lehman Brothers, which made the largest bankruptcy filing in history on Sept. 15.
Lehman Brothers Holdings was the guarantor on the derivatives contracts, which are unregulated, while two subsidiaries, Lehman Brothers Special Financing and Lehman Brothers Derivative Products Inc, were counterparties on them and filed for bankruptcy separately in early October.
Of the 930,000 contracts, roughly 733,000 have been terminated and Lehman wants the court to permit it to assess the as-yet uncalculated termination payments it believes are due to be paid to it in the current market - payments that would add to its total amount of assets.
For the roughly 200,000 contracts that are still outstanding, Lehman wants the court to streamline the process of selling the derivatives contracts to third parties by allowing it to assign them to new counterparties without having to receive the court's approval for each contract.
But more than 100 municipal issuers and private and publicly owned companies that are counterparties on the outstanding contracts are objecting to Lehman's proposal. They argue that they may be forced to do business with firms whose identities are not revealed to them and whose ratings may be lower than Lehman's before its bankruptcy filing.
Some swaps experts are angry, arguing that Lehman is attempting to "hijack" the bankruptcy proceedings on these contracts by asserting authority it does not have under the terms of many of the documents, which generally follow master agreements created by the International Swaps and Derivatives Association.
The ISDA documents stipulate that the non-defaulting party, which would not be Lehman, has the right to control the assignment of replacement counterparties and the termination amount of the contracts.
"This is absolutely unprecedented and is an attempt to throw out decades-old architecture developed, with Lehman's participation, by ISDA," said Peter Shapiro, managing director of Swap Financial Group in South Orange, N.J. who is not involved in the proceedings. "This is architecture that was developed by dealers for dealers, and it was developed on the theory that the dealers needed this architecture because they expected that it would be their clients that would go into bankruptcy, not themselves. Now that the shoe is on the other foot, Lehman is trying to change the rules."
ISDA officials declined to comment on the case.
In a filing with the bankruptcy court, Lehman breaks down the vast number of derivatives on its books into broad categories; most are securities contracts, forward contracts, repurchase agreements, or swap agreements. Though the firm does not provide specific numbers for each category of swap, derivatives market participants believe that roughly 20% to 30% of the contracts are municipal securities-based interest rate swaps.
Lehman is being represented by Weil, Gotshal & Manges LLP and Alvarez & Marsal Holdings LLC, whose attorneys or spokesmen declined to comment.
Court action is needed, Lehman has told the court, because many of the non-defaulting counterparties on the swaps have chosen not to terminate their contracts and because movements in the financial market could change the net amounts they currently owe Lehman.
Their actions might "destroy the value available to [Lehman's estates and stakeholders] ... thus providing a windfall to counterparties," the firm stated in a filing submitted last month to the court. "In short, the assumption and assignment procedures would simply hold each counterparty to its agreement in the derivative contract and prevent it from reaping an inequitable windfall at the expense of the debtors and their creditors."
Lehman told the court that it should be allowed to calculate the termination payments. "Due to the number of derivative contracts and ordinary course nature of resolving terminated derivative contracts, authorization of settlements... [it] is appropriate to conserve estate and judicial resources and maximize the value of the debtors' estates," it argued.
Shapiro and others said that the firm's arguments are faulty because rather than having lost value, the existing contracts have actually increased in value since Lehman's holding company filed for bankruptcy. During the time, overall long-term rates have dropped and the firm's variable rate payments to its counterparties have in turn fallen.
While most of the derivatives contracts are "in the money" for Lehman, they are "out of the money" for municipal counterparties that are mostly paying fixed rates, at higher than prevailing rates, to the firm.
Shapiro contends that the non-defaulting party is supposed to have the right to make a good-faith determination of the termination amount based upon rules established in the contracts, usually through a process called "market quotation."
"The ISDA architecture provides for an effective way; it's not cumbersome and it's not difficult," he said. "Certainly Lehman cannot contend that it was an unsophisticated entity taken advantage of by small municipalities around the country. That's just as far-fetched a contention as you can get."
But bankruptcy attorneys said that regardless of the language in the contracts, bankruptcy law gives Lehman wide latitude to assert control over its assets, pointing to specific provisions that allow Lehman to assign a contract to new counterparties as long as it provides "adequate assurance of future performance under such contract or lease."
"Notwithstanding the language in the derivative contract, the bankruptcy code allows Lehman to do that," said Todd Duffy, a partner at Duffy & Atkins LLP in New York, a remark that suggests this is partly a dispute about contract and bankruptcy law.
Duffy wrote an objection to Lehman's proposals on behalf of the South Mississippi Electric Power Association and the Coast Electric Power Association. It argues the firm should not be allowed to assign new counterparties with a credit rating lower than Lehman's the day before its bankruptcy filing.
The South Mississippi Electric Power Association entered into two separate $20 million interest rate swaps contracts with Lehman Brothers Special Financing in April 2007, while the Coast Electric Power Association entered into a $35.5 million interest rate swap contract with the Lehman unit.
On Sept. 14, the day before Lehman filed its bankruptcy petition, the holding company was rated A2 by Moody's Investors Service. But Lehman wants to be able to assign new counterparties to the contracts that have minimum ratings of A3 Moody's and A-minus from Standard & Poor's and Fitch Ratings.
"Given that the debtors [Lehman] on the day before their bankruptcy filing couldn't have met the financial burden of these agreements and that the rating agencies have had numerous, well-publicized failures in their efforts to predict the financial performances of a potential assignee, the one-size-fits-all procedure that the debtors seek to impose on their counterparties is woefully inadequate under the law," Duffy wrote.
But "even more distressing," the filing said, is that Lehman has proposed to give their existing counterparties just five days to sign off on the assignment of a third-party replacement for Lehman on the derivatives.
"If the debtors [Lehman] chose to sell the agreements to non-qualified assignees, the counterparties to these agreements will be given virtually no notice of the proposed assignments or of the proposed assignee's ability to perform under the agreement," Duffy wrote.
Under Lehman's current proposal, he said, the counterparties will not be given "any financial information bout the unqualified assignee and will allow only five business days from the date they give notice (not the date of receipt of such notice) for the counterparty to determine the financial wherewithal of the proposed assignee."
In a separate "limited objection," New York's Metropolitan Transportation Authority raised some of the same concerns, arguing that by only providing a credit rating and no additional financial information on the new counterparties to which the contracts would be assigned, Lehman would "not provide adequate assurance of an assignee's future performance."
The MTA entered into two interest rate swap agreements with Lehman as well as a reserve fund forward delivery agreement, according to the authority's filing with the court, which was written by attorneys at Nixon Peabody, LLP.
The MTA said that to protect its interests, it completed a rigorous selection process in 2006 to identify and approve eligible counterparties. The process, which took over a year to complete, required each candidate to respond in writing to detailed questions about their fitness to serve as a counterparty. The MTA selected the group of eligible counterparties on four distinct criteria that were independently scored by a selection committee.
"As has been readily apparent in the recent financial crisis, credit ratings are not always the best indication of a party's creditworthiness," MTA said.
In another filing, attorneys at Kutak Rock LLP, writing on behalf of Denver, objected to the five-day period that Lehman proposes to give its counterparties to object to the motion.
Lehman Brothers Special Financing and Denver are parties to an airport system interest rate swap agreement dating back to January 1998 with an initial notional amount of $100 million, and a separate interest rate swap agreement with the same unit of Lehman from June 2006 with an initial notional amount of $120.6 million.
In its filing, Denver argued that the five days of notice for an objection is "patently unreasonable" and cited a 1950 Supreme Court decision, Mullane, Special Guardian v. Central Hanover Bank & Trust Co., in which the court wrote: "When notice is a person's due, process which is a mere gesture is not due process."
In addition, while Lehman argued that the court approved similar procedures in bankruptcy for three large corporations, including Enron Corp., Denver noted that those procedures did not actually involve or address the assumption and assignment of contracts in the expedited manner Lehman seeks for its derivatives.
While many market participants are objecting to the terms of the procedures Lehman outlined for assigning new counterparties, some issuer officials concede that the process does have some benefits. One issuer official who did not want to be identified said he is trying to find new counterparties to replace Lehman but is having a difficult time because of the favorable terms that it agreed to when the municipality entered into the contract.
Specifically, the official said he has been unable to find counterparties willing to replicate so-called one-way collateral and the relatively low $2.5 million threshold limits in his Lehman swap contracts.
One-way collateral means that only one side of the swap transaction ever has to post collateral. In these contracts, typically only Lehman had to post collateral and not municipal issuers.
Collateral is usually required from the party that is out of the money on a swap. The collateral is used by the other party as a check in case their counterparty defaults on its payments. The threshold requirements reflect the mark-to-market value of the swap, above which the party must post collateral.
But in today's troubled market, few bank counterparties are willing to accept one-way collateral because of concern about municipal credits. Many are asking for threshold requirements of $20 million to $30 million, which is a significant amount of credit risk many municipal issuers to take on. But banks and securities firms that have been squeezed by the financial crisis do not want to be bothered with a lower threshold.
"The one advantage to sitting back and having Lehman assume and assign a new counterparty is that whoever the assignee is has to accept our swap as is," the issuer official said.
Sources said Friday that attorneys for Lehman planned to introduce an amended proposal with the bankruptcy court before the hearing tomorrow that reflects some of the counterparties' most common objections, but the firm's attorneys could not be reached for comment.