E-Alert
LEHMAN BROTHERS BANKRUPTCY
A NOTE TO COUNTERPARTIES, DERIVATIVE AND OTHERWISE
Lehman Brothers Holding, Inc. filed a voluntary petition under Chapter 11 of the U.S. Bankruptcy Code on Monday, September 15, 2008, in the United States Bankruptcy Court for the Southern District of New York. With substantial trades in credit, equity, commodity, interest rates and currency derivatives, Lehman’s bankruptcy is expected to have a significant impact on the over $62 trillion derivatives market and many other markets and transactions including CMBS and other ABS servicers, Lehman’s borrowers, and loan participants with Lehman. It is important to note that, as of Monday, September 15, 2008, only Lehman Brothers Holding, Inc. had filed. Subsidiaries and affiliates of Lehman had not yet filed. Any of them could be put in bankruptcy at any time so counterparties must exercise maximum caution in dealing with them. For example, a party buying assets from a Lehman affiliate needs to be especially concerned about fraudulent transfer exposure in a future bankruptcy of the affiliate. The following Alert covers some of the issues that various counterparties and other contract parties on the other side of Lehman will face due to Lehman’s bankruptcy filing. Click here for an in-depth discussion of executory contract issues in bankruptcy by Dan Flanigan, Chair of our Financial Services and Real Estate Department. For assistance concerning the matters described in this Alert or other matters related to the Lehman situation, please contact Dan Flanigan, Chair, Financial Services and Real Estate Department, by phone (212-644-2090 or 816-360-4260) or email dflanigan@polsinelli.com.
Securities Brokerage Customers
Lehman’s brokerage business is not in bankruptcy. In any event, investors with brokerage accounts should be covered up to $500,000.
Derivatives Counterparties/Financial Markets Contracts
In order to reduce the initial shock to the market, the International Swaps and Derivatives Association, Inc. (“ISDA”) held an extraordinary four-hour trading session on Sunday, September 14, 2008, to permit parties to enter into transactions with other participants that would fully or partially offset any over-the-counter (“OTC”) derivatives in place with Lehman. The effectiveness of these transactions was contingent on Lehman filing bankruptcy by 11:59 p.m. Sunday. The bankruptcy was not filed until Monday, September 15. Any participant that has entered into an OTC derivative trade with Lehman as a counterparty, and did not attend the ISDA trading session on Sunday, should review the master agreement and credit support documentation in place in connection with such trade to determine whether or not a default
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has occurred. If a default exists, then the participant(s) may be allowed (depending on the terms of the documents) to: (a) close out the contract with Lehman, (b) determine the net amount owing amongst participants, (c) take into account any collateral that may secure the trade; and (d) pursue recourse against Lehman pursuant to the terms of their particular documentation. Most if not all derivative trades are included in a class of contracts that are not affected by the “automatic stay” imposed upon the filing of a bankruptcy petition, so counterparties may be able to take action against Lehman immediately including offset or netting out of any termination value, payment amount, or other transfer obligations arising under or in connection with the contract.. Such contracts include swaps and other commodity contracts, forward contracts, and “securities” contracts (e.g. a contract for the purchase, sale, or loan of a security, a certificate of deposit, a mortgage loan, or any interest in a mortgage loan, a group or index of securities, certificates of deposit, or mortgage loans or interests therein, or option on any of the foregoing).
Commercial Loan Participants
A purchase, sale, or repurchase obligation under a participation in a commercial mortgage loan is not defined as a “securities” contract or other protected contract allowing setoffs and other actions without interference from the automatic stay of the debtor’s bankruptcy. A properly drafted participation agreement where the debtor is a participant vests ownership of the participation interest in the loan in the debtor. Other participants in the loan will need to be concerned about the debtor’s ability and authority to honor any funding obligations or give consents or approvals under the participation agreement. A properly drafted participation agreement where the debtor is the seller of the participation vests ownership of the participation interest in the loan in the participant and may not be recharacterized as debt nor may the ownership of the participation be rejected as an executory contract. If the debtor is acting as agent or lead lender, there will be various potential complications and difficulties including the possible ability of the debtor’s rejection of the debtor’s forward obligations under the agreement as an executory contract.
Other Contract (Executory Contracts)
These would include contracts for the provision of goods or services. Servicing contracts are probably included in this category. Lehman has the right to assume or reject these contracts up to the time of confirmation of a plan (other than leases of nonresidential property, which must be assumed or rejected within 210 after filing of the case). Assumption of such contracts results in a likely post-petition administrative expense (though many bankruptcy estates become administratively insolvent and not all such claims can be paid). Rejection of such contracts results only in an unsecured claim for breach damages as of the petition date. Anyone performing services or providing goods postpetition under such a contract is at risk of not getting paid for the postpetition goods or services.
Other Contract (Non-Executory Contracts)
At the risk of grossly oversimplifying a very complex subject, if there are no further obligations to perform by one of the parties to the contract, it is probably not executory. For further discussion see Dan Flanigan’s attached piece on executory contracts. Click here for an in-depth discussion of executory contract issues in bankruptcy by Dan Flanigan, Chair of our Financial Services and Real Estate Department.
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Intercreditor Agreement/Subordination Agreement
This type of agreement is arguably not executory. If it were a simple subordination agreement, there would presumably be no duties left on either side. Modern intercreditor agreements are more complex, but most of the obligations are to refrain from doing particular things. While their status is unsettled, these may well not be executory contracts.
Partners and Joint Ventures
Courts have held that partnership and joint venture agreements are not executory contracts but the case law is conflicting. Major and complicated issues are enforceability of funding obligations of the debtor and buy-sell, right of first refusal, and purchase option provisions in these agreements.
Financial Accommodations Contracts
A contract to make a loan or extend other debt financing or financial accommodations to the debtor may not be assumed by the debtor.
“Personal Service” Contracts
If a contract can be characterized as a “personal service” contract, it cannot be assigned by the debtor, and in some courts cannot even be assumed by the debtor, in the bankruptcy case.
Licensees and Tenants
Licensees of intellectual property and tenants of real property have special protections under the Bankruptcy Code.
Landlords
Landlords also are specially treated under the Bankruptcy Code. Rent incurred postpetition must be paid currently. But if a lease is rejected, the landlord’s resulting unsecured claim is limited.
Contracts Under Negotiation
Parties negotiating with Lehman as of the filing where a contract has not been executed need to determine whether they should insist on court approval of the contracts. Whether a contract is within the “ordinary course” of the debtor’s business, and thus does not require court approval, can be hard to determine and the risk is on the counterparty. If the issue is at all doubtful, and even if it appears not to be doubtful (since debtors and bankruptcy trustees, poking around for money wherever they can find it, have a way of taking aggressive positions on these issues later in the case), the party needs to consider requiring court approval, credit enhancement (from a nondebtor party), or other protection from an adverse finding on the ordinary course issue.
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Borrowers
Borrowers seeking approvals and consents will need to determine whether the debtor, and the representatives of the debtor it is dealing with, are authorized to grant these. Borrowers who are parties to an interest rate swap where Lehman or an affiliate of Lehman has an obligation to make interest payments may soon find themselves scrambling to substitute an acceptable counterparty if the loan documents require substitution upon the occurrence of a Lehman bankruptcy or ratings downgrade or similar adverse credit event.
First Mortgage Holders When Debtor Is a Second Mortgage Holder
The automatic stay of the debtor’s bankruptcy prevents the first mortgage holder from foreclosing without obtaining relief from the automatic stay.
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For assistance concerning the matters described in this Alert or other matters related to the Lehman situation, please contact Dan Flanigan, Chair, Financial Services and Real Estate Department, phone (212-644-2090 or 816-360-4260) or email dflanigan@polsinelli.com.
This Alert is prepared as a source of general information concerning recent developments. This Alert is not legal advice or an opinion. No action should be taken in reliance upon this Alert without obtaining the advice of a knowledgeable attorney. The choice of an attorney is an important decision that should not be based solely upon advertisements.
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