Court Upholds Creditor-Friendly Liquidation Procedure

The statutory safe-harbor provisions within the U.S. Bankruptcy Code provide nondebtor parties to certain types of agreements, such as swap and forward contracts, with the unique right to terminate based solely upon the commencement of bankruptcy and to immediately liquidate the damages arising from such termination despite the automatic stay. Recently, the U.S. Bankruptcy Court for the Southern District of New York issued an important ruling further defining the scope of these “safe harbor” protections in Michigan State Housing Development Authority v. Lehman Brothers Derivative Products (In re Lehman Brothers Holdings), 2013 Bankr. LEXIS 5317 (Bankr. S.D.N.Y. Dec. 19, 2013). Through its opinion, the court ruled that the contractual methodology for conducting the liquidation of a swap agreement was protected by the safe-harbor provision, notwithstanding the fact that the agreement before the court shifted the damage calculation in a manner less favorable to the debtor party solely as a result of its bankruptcy filing. This decision confirms that the safe-harbor right to liquidate swap agreements triggered by a bankruptcy filing includes application of the liquidation procedures specifically set forth in the swap agreement, even if such calculation is prejudicial to the debtor.

In May 2000, the Michigan State Housing Development Authority (MSHDA) entered into an International Swaps and Derivatives Association (ISDA) master agreement with Lehman Brothers Derivative Products (LBDP), an affiliate of Lehman Brothers Holdings Inc. (LBHI). MSHDA and LBDP entered into 20 interest-rate swap transactions under the master agreement prior to LBHI’s bankruptcy filing. Although the bankruptcy filing constituted a termination event under the master agreement, rather than terminating the outstanding transactions, MSHDA and LBDP entered into an assignment and amendment agreement with Lehman Brothers Special Financing (LBSF), a nondebtor at the time, pursuant to which all of LBDP’s rights and obligations under the master agreement and outstanding transactions effected thereunder were assigned to LBSF. The assignment agreement contained an express provision (liquidation paragraph) that required use of the “mid-market” method for calculating the amount owed (settlement amount) upon termination of the transactions, unless termination was due to the nonpayment or bankruptcy of LBSF, in which case the “market quotation” method would be applied.