Focus: Lehman, Metavante and ISDAs: shutting stable doors after counterparties have bolted?
21 October 2009
In brief: In Australia and other jurisdictions, the 'flawed asset' aspect of the ISDA Master Agreement is a powerful weapon in the hands of parties dealing with insolvent counterparties. However, the recent US case of Lehman Brothers and Metavante has weakened it in the US context. Partners Diccon Loxton (view CV) and Tom Highnam (view CV) and graduate trainee* Tom Gibson analyse the decision and its likely effects on existing swap agreements.
* England & Wales only
- The factual background
- The decision
- What is the effect of the decision in the US?
- What do ISDA have to say?
- What about in Australia?
How does it affect you?
- Section 2(a)(iii) of the ISDA Master Agreement makes the obligation of each party conditional on the other making payments and there being no Event of Default. This operates as a mechanism for a non-defaulting party to stop making payments under a swap agreement where the counterparty is insolvent (or is in default in some other way).
- A party's ability to stop making payments in this way to a US counterparty may now be affected by the decision of the US Bankruptcy Court in the Lehman Brothers and Metavante Technologies case (15 September 2009, New York).
- The decision shows that, in the US, the failure to exercise termination rights fairly soon after a counterparty's bankruptcy may constitute – in spite of contractual provisions to the contrary in the ISDA Master Agreement – a waiver of that right.
- The decision has to be viewed against the backdrop of the applicable US bankruptcy law. In Australia, or another jurisdiction, a similar scenario would result in a very different outcome.
Metavante was a swap counterparty of Lehman Brothers under an interest rate swap governed by an ISDA Master Agreement. Metavante chose not to terminate the agreement upon Lehman's bankruptcy (an event of default) in October 2008. Under the ISDA Master Agreement, a delay in exercising such a right to terminate does not constitute a waiver of that right.
Instead, Metavante relied on s2(a)(iii) of the ISDA Master Agreement. This provision, a condition precedent to Metavante making payments under the swap, was not satisfied while an event of default (Lehman's bankruptcy) was continuing. This, therefore, allowed Metavante to stop making payments during Lehman's bankruptcy.
By 29 May 2009, Metavante owed Lehman more than US$6.3 million, comprising the November 2008, February 2009 and May 2009 quarterly payment dates under the swap agreement, along with default interest1.
Lehman petitioned the US Bankruptcy Court to compel Metavante to continue to perform the ISDA Master Agreement. Lehman also asked the court to declare that Metavante's termination rights had become subject to an automatic stay.
Metavante argued that, as the non-defaulting party, it had the right to wait, and then to terminate the swap agreement later once market conditions had moved in their favour. Lehman, however, argued that Metavante was improperly attempting to take advantage of its chapter 11 bankruptcy, in contravention of the US Bankruptcy Code.
In particular, Lehman relied on s365(e)(1) of the US Bankruptcy Code, which states that:
Notwithstanding a provision to the contrary in an executory contract... an executory contract... may not be terminated or modified... solely because of a provision in such contract... that is conditional on: (a) the insolvency or financial condition of the debtor; [or] (b) the commencement of a case under this title...
On 15 September 2009, Judge James Peck ruled in favour of Lehman. He found that the ISDA Master Agreement was subject to the general executory contract provisions of the Bankruptcy Code2, meaning that Metavante could not rely on s2(a)(iii) (as its ability not to pay was conditional on Lehman's bankruptcy, and therefore fell within the scope of s365(e)(1) above). While Metavante had previously had the right to liquidate, terminate or accelerate the swap, it had waived that right by failing to exercise it within a reasonable period of time.
We understand the decision is likely to make it harder to rely on s2(a)(iii) to stop making payments to bankrupt swap counterparties under the ISDA Master Agreement. Instead, counterparties may need to choose, reasonably soon after the bankruptcy, whether to call an early termination or to continue to perform the contract.
ISDA appear to have been unruffled by the decision, with General Counsel David Geen telling the Financial Times3:
We didn't learn anything in Metavante we didn't already know... It's just another reminder that [ISDA] agreements are always subject to local bankruptcy laws... people dealing in the US would have been advised that 2(a)(iii) and the right to terminate is going to be affected by applicable law even if it's not specified in the agreement.
However, it seems as though at least the US market may not have shared ISDA's view. The Financial Times reported that the decision had 'blindsided the market', because 'nothing like this had ever happened in the US'4.
Similar issues were considered in the New South Wales case of Enron Australia v TXU Electricity Ltd (2005) 53 ACSR 295, which involved s2(a)(iii) of the ISDA Master Agreement in the context of electricity swap contracts. In this case, the liquidators of Enron Australia applied to the court for an order (under s568(1B)(b) of the Corporations Act 2001 (Cth)) to vary TXU Electricity's payment obligations under the swap agreement.
However, the result under the Corporations Act was the opposite to that under the US Bankruptcy Code. The Court of Appeal (of the Supreme Court of New South Wales) agreed with the view of the Equity Division that the Corporations Act would respect the original swap agreement. Specifically, the Equity Division held that5:
It [s568(1B) Corporations Act] does not, as a matter of construction, permit the court to deprive the counterparty [TXU Electricity] of its contractual rights, such as the right not to designate an early termination date under s 6(a) after an event of default occurs and the right under s 2(a)(iii) not to make a payment under s 2(a)(i) while an event of default continues.
The Metavante case was decided under US law. In Australia (or another jurisdiction), as the differing results of these two cases illustrate, the way a court treats the ISDA Master Agreement would be very different. It is therefore necessary, in any jurisdiction, for swap counterparties to look beyond the ISDA Master Agreement to the applicable law behind it.
- Page 103, hearing transcript of In Re Lehman Brothers Holdings Inc., No. 08-013555 (JMP) (Bankr. S.D.N.Y. Sept. 15, 2009).
- 'Although complicated at its core the [ISDA Master] Agreement is, in fact, a garden variety executory contract'; page 109, hearing transcript.
- 'Lehman, Metavante and the ISDA Master Agreement'; FT.com Alphaville blog; 30 September 2009.
- ibid, footnote 3.
- Paragraph 44, Enron Australia v TXU Electricity Ltd (2003) 48 ACSR 266.
- Tom HighnamPartner,
Ph: +61 2 9230 4009
- Diccon LoxtonPartner,
Ph: +61 2 9230 4791
- John GallimorePartner,
Ph: +61 7 3334 3135
- Tim LesterPartner,
Ph: +61 8 9488 3841