When (derivatives) counterparties collapse | FT Alphaville

When (derivatives) counterparties collapse

Lehman Brothers — not just the catalyst of the recent financial crisis, but also the reason for a helluvalot of legal wrangling, notably in the heady sphere of derivatives.

In fact, just before FT Alphaville left for Christmas, an interesting case covering a vital piece of derivatives documentation made its way through the English courts. Now that we’ve had time to digest it (and our Christmas cookies) we’d like to share.

So lie back and think of swaps — vanilla and more complex.

Or better yet — lie back and think of counterparty risk management.

Before the Lehman-spurred crisis, most risk management seemed focused on things like hedge funds. Now though, we have a cast of counterparty monsters that include everything from monoline insurers to banks like Lehman and even (gulp) sovereigns.

Focus, for now though on Lehman.

Vanilla swaps are governed by the Isda Master Agreement — which is basically the bible of the derivatives industry. Not only does it enable you to trade with the big boys of Wall Street, but it also governs the way you’re meant to do it.

According to the Isda Master then, when one counterparty to a swap defaults (à la Lehman) the non-defaulting party can opt to close out the swap at fair value. Such close-outs are even allowed under the safe harbour provisions of strict US bankruptcy laws (instead of automatic stay). However, the rights to close out under safe harbour provisions have to be exercised within a “reasonable period of time” — something we learned in the 2009 Lehman vs Metavante Technologies case.

Back over to the English courts for now though and the question of what happens when the non-defaulting party elects not to close out the swap. Section 2(a)(iii) in the Isda Master says that payment obligations are subject to the “condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing”. That’s legal speak for payment obligations are dependent upon a counterparty not being in default. So can a non-defaulting counterparty not only elect to not close out, but also to suspend making payments? Or, the equivalent of having your (vanilla swap) cake and eating it too?

We want you to meet JFB Firth Rixson Inc, FR Acquisitions Corp (Europe) Ltd, BEIG Midco Ltd and KP Germany Zweite GmbH — four companies that opted to not only not close out their interest rate swaps with Lehman Bros after its bankruptcy, but also stopped making payments. In 2010 the swaps were out-of-the-money for the companies (or, in the money to Lehman) to the tune of about £60m. Unsurprisingly, the Lehman estate challenged their decision in the English courts.

The court decision (in a nutshell) ruled in favour of the companies — non-defaulting counterparties could indeed choose not to close out swaps and suspend making payments after their other counterparty defaults. BUT those counterparties would have to make good on those payments if the default were ever cured.

There’s a whole host of English anti-deprivation law (which basically seeks to protect assets that would otherwise benefit the creditors of an insolvent estate) to go along with the ruling. Essentially though, Lehman lost, and companies won.

What though of the Isda Master Agreement?

According to Clifford Chance (which represented BEIG Midco Ltd) the court ruling was effectively a win for the Isda Master — it meant the document “does what it says on the tin.” It’s worth noting though, that questions over more complex swaps are still hovering in the background. For instance, we can expect another dose of anti-deprivation debate when the UK Supreme Court considers flip clauses this March. The Lehman estate also still has the option to appeal against some of the court’s decisions in this swap ruling (including those on anti-deprivation).

Not to mention what’s going on across the Atlantic. We name-checked Metavante earlier for a reason. A US bankruptcy court ruled in September 2009 that the company fell outside of safe harbour provisions because they didn’t close out their swaps within a “reasonable period of time;” Metavante was still obligated to pay. Meanwhile Section 2(a)(iii) became far less relevant for swaps with US-based dealers.

So for the moment, we have a bizarre situation where counterparty risk is still (attempting to be?) dealt with by what’s meant to be coordinated regulation (viz the Isda Master doc) but there remain major splits between the two sides of the Atlantic in the way the regulations/provisions/sections etc. are legally enforced.

Go long lawyers.

Related links:
The Lehman flip – FT Alphaville
Lehman, Metavante and the ISDA Master agreement – FT Alphaville
English High Court rules on the construction and effect of Section 2(a)(iii) – Allen & Overy