Pre-financial crisis, interest rate derivatives were widely recognized as a valuable part of the municipal issuer's financial toolkit. Post-crisis, they have been a thorn in the side of many issuers, resulting in expensive litigation with failed swap providers — most notably the Lehman and Ambac derivatives trading subsidiaries — and public criticism of municipal issuers said to have fallen prey to more sophisticated providers
There are several lessons to be learned from the recent spate of litigation. These lessons may come into sharp focus in the coming months — the time for Lehman to bring claims against counterparties who terminated derivative instruments shortly after its bankruptcy filing will expire in the third and fourth quarters of 2014, and Lehman presumably will bring into court a large number of disputes that have not been resolved in the Bankruptcy Court-ordered alternative dispute resolution process. These same lessons will be valuable for counterparties facing other financially distressed swap providers in the future, and many of the lessons also apply where the trade is "in the money" to the counterparty, including for many issuers who entered into forward delivery agreements with Lehman.
Lesson One — Don't Believe Everything You Read
Both Lehman and Ambac have argued that the amount due upon the early termination of an interest rate swap or other derivative is the "mid-market" value — that is, the present value of the difference between the two cash flows being exchanged. They are wrong.
The supposed holy grail "mid-market" number ignores many factors that impact the market value of a derivative, such as credit charges, hedging costs and dealer profit margin. The standard ISDA swap documentation provides for these market considerations to be taken into account, and both Lehman and Ambac have acknowledged these market factors in other contexts. Simply put, no one actually trades at mid-market.
Lehman and Ambac prefer "mid-market" numbers because they exclude market discounts, and thus maximize the amount that the provider can claim is due it (or, conversely, minimize the amount due from the provider on "out of the money" trades). Neither market realities nor the parties' contractual arrangements, however, support this argument.
Lesson Two — Be Careful What You Wish for
When it became apparent that one of Lehman's "AAA"-rated swap providers — Lehman Brothers Derivative Products, Inc. — would be filing for bankruptcy, Lehman asked many LBDP counterparties to switch their agreements from LBDP to another Lehman trading subsidiary, and offered counterparty-friendly termination provisions as an inducement. After the second Lehman entity also filed for bankruptcy, counterparties took advantage of the new provisions.
Lehman then did an about face, arguing that these provisions are invalidated by the Bankruptcy Code. Lehman is testing this dubious theory in litigation with the Michigan State Housing Development Authority that has not yet been decided.
The lesson here is to be skeptical of concessions offered by a distressed swap provider, who may later attempt to use bankruptcy laws to shield it from its own 11th hour agreements.
Lesson Three — The Clock Is Ticking
The termination of derivative instruments is generally "safe harbored" under the Bankruptcy Code — that is, a counterparty may terminate a swap based on the bankruptcy filing of its swap provider without running afoul of the Bankruptcy Code's "automatic stay." The judge overseeing the Lehman bankruptcy, however, has ruled that this safe harbor has a limited shelf life. While the court did not specify for how long a termination is safe harbored, it has ruled that a year is too long to wait. This ruling has been subject to criticism, and has not been vetted by an appellate court. It does, however, provide a cautionary tale for those evaluating their options after the failure of a swap provider.
Lesson Four — Think Twice Before Filing a Bankruptcy Claim
An immediate reaction upon learning of a bankruptcy is to promptly file any claims that may exist against the debtor. Such claims were filed, for instance, by parties to forward delivery agreements that were "in the money" to them when Lehman filed for bankruptcy. There may also be examples in which an issuer or other borrower may have filed claims against Lehman unrelated to its derivatives contracts, even though the issuer was also a counterparty to an interest rate swap that was "out of the money" to it. Filing such a claim may well be prudent, particularly in the face of an impending bankruptcy bar date.
There are, however, potential risks to a counterparty filing a claim unrelated to the swap in a swap provider's bankruptcy case. Doing so may, for instance, subject the counterparty to the Bankruptcy Court's jurisdiction for all purposes in the bankruptcy case, possibly with unintended consequences. Also, counterparties may under some circumstances be entitled to have their claims heard in a Federal District Court, instead of the Bankruptcy Court, and decided by a jury rather than a judge. There is a risk that these rights may be waived by filing a claim. It may nonetheless make sense to do so, but these risks should be considered.
Lesson Five — Don't Forget the Fundamentals
The standard ISDA documents include many technical requirements for swap termination — addressing, for instance, how default and termination notices are to be delivered, and when and how early termination payments are to be calculated. Failure to comply with these technical requirements — even if it is the unavoidable consequence of market conditions — will be used by the distressed swap provider as a basis to dispute that the termination was effective or that the correct breakage amount was calculated. The swap provider may well challenge one or both of these things even when everything is done correctly, but taking proper care and documenting market conditions that may have forced technical non-compliance can only strengthen the issuer's position.
Steven Fink is a Commercial Litigation Partner,
Thomas Mitchell is a Bankruptcy Partner and Nikiforos Mathews
is a Structured Finance and Derivatives Partner,
all with Orrick, Herrington & Sutcliffe LLP.