September 29, 2009

In a recent bench ruling issued in the Lehman Brothers Chapter 11 proceedings in the Southern District of New York, Bankruptcy Judge James M. Peck held that (i) non-debtor counterparties to swap transactions with a debtor may not rely on Section 2(a)(iii) of the ISDA Master Agreement as a basis for withholding performance on account of the debtor's bankruptcy filing and (ii) although the Bankruptcy Code safe harbors for swap agreements and other derivative transactions protect the right of the non-debtor counterparty to terminate and net transactions, such right may be deemed waived if not exercised "promptly" upon a debtor counterparty’s bankruptcy filing.


Metavante Corporation ("Metavante") and Lehman Brothers Special Financing, Inc. ("LBSF") were parties to an interest rate swap entered into pursuant to a 1992 ISDA Master Agreement. Under the swap, LBSF had agreed to make quarterly payments based on a floating interest rate on a notional amount of $600 million and Metavante agreed to make payments on the same dates based on a fixed interest rate on the same notional amount. Pursuant to the terms of the ISDA Master Agreement, payments are required to be made on a net basis by the party that owes the larger amount. LBSF’s obligations under the Master Agreement were guaranteed by Lehman Brothers Holdings, Inc. ("LBHI").

The Chapter 11 filings of LBSF and LBHI constituted Events of Default under the ISDA Master Agreement, entitling Metavante to terminate the transaction. However, due to declining interest rates, the value of LBSF's position (which was based on a floating interest rate) had increased significantly, with the result that the swap was out of the money to Metavante. Although Metavante would have been permitted to terminate the transaction post-petition under the applicable safe harbor provisions, sections 560 and 561 of the Bankruptcy Code, it did not do so (presumably because this would have required Metavante to make a termination payment to LBSF), but instead kept the swap open and withheld performance in reliance on Section 2(a)(iii) of the ISDA Master Agreement, which provides:

(iii) Each obligation of each party [to make a payment or delivery under each Confirmation] is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing, (2) the condition precedent that no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated and (3) each other applicable condition precedent specified in this Agreement.

LBSF moved to compel Metavante to perform, claiming that Metavante owed LBSF approximately $6.6 million, representing net payments accrued on the November 2008 and February and May 2009 payment dates, plus default interest. Metavante countered that it had the right, under the ISDA Master Agreement and New York law, to withhold performance based on the failure of a condition precedent, and that although the Bankruptcy Code safe harbors afforded it the right to terminate the transaction, it was under no obligation to do so at any particular time.


The bankruptcy court agreed with the debtors that the agreement between Metavante and LBSF, as represented by the swap transaction and the ISDA Master Agreement (the "Agreement"), "is a garden variety executory contract, one for which there remains something still to be done on both sides."[1] On this basis, the court observed that, even if not yet assumed, under relevant case law an executory contract is enforceable by a debtor against the counterparty and agreed with the debtors that "while a debtor determines whether to assume or reject an executory contract the counterparty to such contract must continue to perform."[2]

Turning to the safe harbor provisions, the court found that "[i]t is . . . clear . . . that the safe harbor provisions . . . protect a non-defaulting swap counterparty's contractual rights solely to liquidate, terminate or accelerate one or more swap agreements because of a condition of the kind specified in Section 365(e)(1) or 'to offset or net out any termination values or payment amounts arising under or in connection with the termination, liquidation or acceleration of one or more swap agreements',"[3] and that "[a]ll other uses of ipso facto provisions remain unenforceable under the Bankruptcy Code."[4] Accordingly, the court held that the safe harbors did not provide Metavante a basis to withhold performance under a swap that it had not yet chosen to terminate.

The court cited the legislative history of the safe harbors, which, according to the court, evidences Congress's intent to allow for the prompt closing out or liquidation of open accounts upon the commencement of a bankruptcy case "for the protection of all parties in light of the potential for rapid changes in the financial markets."[5]

Based in part on this legislative history, the court held that Metavante's "conduct of riding the market for the period of one year, while taking no action whatsoever, [was] simply unacceptable and contrary to the spirit of these provisions of the Bankruptcy Code."[6]

Then, going beyond the question of whether Metavante was entitled to withhold performance, the court held that Metavante had actually waived its right to terminate the transaction based on the safe harbors by failing to terminate promptly.

Citing an opinion issued in the Enron bankruptcy case for the proposition that "a counterparty's action under the safe harbor provisions must be made fairly contemporaneously with the bankruptcy filing, les[t] the contract be rendered just another ordinary executory contract,"[7] the court found that "Metavante's window to act promptly under the safe harbor provisions has passed, and while it may not have had the obligation to terminate immediately upon the filing of LBHI or LBSF, its failure to do so, at this juncture, constitutes a waiver of that right at this point."[8]

The court held that LBSF was entitled to continued receipt of payments under the Agreement and that "Metavante's attempts to control LBSF's right to receive payment under the Agreement constitute, in effect, an attempt to control property of the estate" in violation of the Bankruptcy Code's automatic stay.[9] Accordingly, the court ordered Metavante to perform under the Agreement until such time as LBSF and LBHI determine whether to assume or reject the contract. Significantly, the court did not set any deadline for the debtors to decide whether to assume or reject.

Metavante has filed a motion to amend the court's order which is currently pending with the court.[10] The motion seeks, among other things, the court's clarification of what assurance the debtors must provide to Metavante as adequate protection that, should in the future the swap be in the money to Metavante, the debtors will be able to make the required payments.

Future Implications

The ruling, one of first impression, has important implications which should be carefully considered. First, the decision indicates that the protections afforded by the Bankruptcy Code safe harbors are limited to the rights of the non-defaulting counterparty to liquidate, terminate and accelerate the protected transaction and to offset or net out the resulting termination values or payments amounts, and that parties to open derivative transactions with a debtor are not excused from performance under the transactions prior to any such termination. Secondly, by holding that Metavante's failure to terminate the swap agreement "promptly" under the safe harbor provisions amounted to a waiver of that right, the decision sends a strong message that the "equities" created by the safe harbor provisions of the Bankruptcy Code do not allow a non-defaulting counterparty to "play the market" once an event of default has occurred. This implication is consistent with the principles that inform another recent ruling issued in the American Home Mortgage Holdings bankruptcy case pending in Delaware, in which Bankruptcy Judge Sontchi wrote that section 562 of the Bankruptcy Code (regarding the timing of damage measurement in connection with the liquidation, termination or acceleration of a protected agreement) does not allow a repo participant to "sit back and monitor market conditions while being protected, at least in part, from market losses by its potential deficiency claim against the debtor."[11]

Judge Peck's ruling raises a number of important questions – among them, how long a non-debtor counterparty has to terminate a protected transaction before its safe harbor rights should be deemed waived and how long (if at all) would a non-debtor counterparty be able to wait before terminating because of a bankruptcy if it did continue to perform.

Judge Peck's ruling contrasts with the holding of a New South Wales, Australia court in Enron Australia v. TXU, where the court concluded that a non-debtor counterparty was entitled to withhold performance pursuant to Section 2(a)(iii) of the ISDA Master Agreement based on an event of default triggered by a debtor-counterparty's insolvency filing. It remains to be seen how courts in other jurisdictions will rule on this issue.


In re Lehman Brothers Holdings Inc., Case No. 08-13555 (JMP) (Bankr. SDNY Sept. 15, 2009) (transcript of record, excerpts)

1. Transcript of Record at 109.
2. Tr. at 106.
3. Tr. at 108-109 (emphasis added).
4. Tr. at 107.
5. Tr. at 111.
6. Tr. at 110.
7. Tr. at 111, citing In re Enron Corp., 2005 WL 3874285 (Bankr. SDNY 2005), at *4.
8. Tr. at 111-112.
9. Tr. at 112.
10. The hearing is scheduled for November 18, 2009.
11. In re American Home Mortgage Holdings, Inc., Case No. 07-11047 (CSS) (Bankr. Del. Sept. 8, 2009), at 17. See Davis Polk Insolvency and Restructuring Update, Sept. 14, 2009.

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