Orrick Derivatives Month in Review

Lehman Bankruptcy Court Addresses Withholding Scheduled Swap Payments to a Bankrupt Counterparty

On September 15, 2009, the United States Bankruptcy Court for the Southern District of New York (the "Court") determined that Metavante Corporation ("Metavante"), a counterparty to an interest rate swap agreement with Lehman Brothers Special Financing ("LBSF"), a bankrupt Lehman entity, was no longer excused from performing under the swap (to the extent it had been at all) and no longer had the ability to terminate the swap.

Metavante had entered into the swap with LBSF in November 2007.  Under the terms of the swap, Metavante was to pay periodic amounts on an amortizing notional amount based on a fixed rate and was to receive periodic amounts on the same amortizing notional amount based on a floating rate (i.e., three-month LIBOR).

LBSF filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code (the "Code") on October 3, 2008.  After that date, in reliance on Section 2(a)(iii) of the ISDA Master Agreement governing the swap, Metavante elected not to make any of the net scheduled payments to LBSF that the swap periodically required.  Section 2(a)(iii) is standard to swap agreements and provides, generally, that a party's obligation to make a scheduled payment is conditioned on there being no default with respect to its counterparty existing at the time such payment is to be made.  Metavante also elected not to terminate the swap based on the bankruptcy, which constituted a default under the swap documentation.[1]  If Metavante had elected to terminate the swap under the market conditions existing at the time of the LBSF bankruptcy filing or at any time thereafter, Metavante apparently would have owed a substantial payment to LBSF in connection with the early termination.[2]

LBSF essentially requested that the Court (i) compel Metavante to continue to perform under the swap, subject to LBSF's right as a debtor to choose to assume or reject the contract[3] and (ii) deny Metavante the ability to early terminate the swap.  In making its petition, LBSF argued that Metavante's failure to make the scheduled payments required by the swap violated the Code because such a suspension impermissibly modified the swap, an executory contract, solely as a result of LBSF's bankruptcy filing.[4]  LBSF further argued that Metavante's nearly one-year delay in terminating the swap should result in Metavante's waiver of its right to do so.

The Court granted LBSF the requested relief.  In particular, the Court referred to an earlier Enron case to support the position that a swap counterparty's right to early terminate, accelerate, liquidate and net its protected contracts despite its counterparty's bankruptcy (known as the "safe harbor" provisions) must be exercised "fairly contemporaneously" with the debtor's bankruptcy filing.

The ISDA Master Agreement itself does not provide a time limit for reliance on Section 2(a)(iii) rights.[5]  Similarly, the Code does not provide a timeframe during which a counterparty must exercise its early termination rights in connection with its protected contracts with a debtor.  The Court's decision does not resolve these points absolutely, although it does provide some guidance to market participants.  In short, the Court made clear that a party is not indefinitely permitted—if at all—to withhold payments while not moving forward with some urgency to close out its existing protected contracts in reliance on the safe harbor provisions of the Code.[6]  Indeed, the Court found that waiting for almost a year before doing so (or in Metavante's case, without attempting to do so at all) is certainly too long.

SEC Extends Temporary Exemptions Granted to Facilitate Central Clearing and Settlement of CDS

On September 14, 2009, the Securities and Exchange Commission ("SEC") issued a release (the "Extension Release") which extended the expiration dates of five interim final temporary rules (the "Interim Rules") it had adopted in January 2009 under the Securities Act of 1933, as amended (the "Securities Act"), the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and the Trust Indenture Act of 1939, as amended, relating to credit default swaps ("CDS").  The Interim Rules were adopted in connection with temporary exemptive orders issued by the SEC to foster the development and facilitate the operation of central clearing counterparties ("CCPs") for eligible types of CDS.  Among other things, the Interim Rules temporarily (i) exempt from all provisions of the Securities Act (except the anti-fraud provisions) eligible CDS transactions that are offered and sold only to "eligible contract participants" (as defined in Section 1a(12) of the Commodities Exchange Act of 2000, as amended) and that are cleared by either a CCP satisfying specified conditions for exemption set forth in its exemptive order or a clearing agency registered under Section 17A of the Exchange Act; (ii) exempt any exchange that effects transactions in eligible CDS from the requirements of Sections 5 and 6 of the Exchange Act to register as a "national securities exchange" and (iii) exempt any broker or dealer that effects transactions on an exchange in eligible CDS from the requirements of Section 5 of the Exchange Act.

In the Extension Release, the SEC noted that, since the adoption of its Interim Rules, it had granted temporary exemptive orders to five CCPs to clear CDS.  Of those five, only one CCP had become actively engaged as a CCP clearing CDS transactions in the United States; the other CCPs had either suspended their efforts, had begun clearing CDS in Europe or continued to work with participants to become operational.  The SEC explained that the purpose of extending the Interim Rules was to allow the CCP that has begun operations to continue to clear and settle CDS transactions[7] and to enable other CCPs to begin operating in a manner contemplated by the exemptive orders, hence increasing competition among CCPs and reducing clearing fees.  The SEC also noted that the operation of CCPs, as facilitated by the existence of the Interim Rules, would enable it to provide oversight to the relevant CDS market through, among other things, the on-site inspection of facilities, records and personnel.

The Extension Release extended the expiration date of the Interim Rules from September 25, 2009 to November 30, 2010, during which period the SEC will continue monitoring the development and operation of CCPs in the CDS market, particularly in light of the evolving regulatory and legislative environment.

ECB Releases Report Regarding OTC Derivatives Post-Trading Infrastructure

In September 2009, the European Central Bank ("ECB") released a report entitled OTC Derivatives and Post-Trading Infrastructures (the "Report").  In 2008, the ECB launched an analysis of the over-the-counter ("OTC") derivatives market and its infrastructure for the primary products entered into in the marketplace (i.e., interest rate swaps, equity derivatives, credit default swaps, foreign exchange derivatives and, although they are not typically categorized as derivatives, repurchase agreements).  This analysis, which focused on the euro-segment of the market, was initiated as a result of concerns over the limited development of post-trading infrastructure for these products, particularly against the backdrop of the recent financial turmoil, and its possible effect on the euro area.  The Report presents the main findings of this analysis, including a summary of the general market characteristics and the current state of post-trading infrastructure, and discusses the policy implications relating to its findings.

The Report first describes each of the product types and its characteristics.  Relying largely on data from the Bank for International Settlements, it also identifies banks and other financial institutions as the main market participants in OTC derivatives by product.  The Report places great weight on what it views as the systemic relevance of the OTC derivatives markets "in particular because of the existence of large exposures between a limited number of financial institutions."[8]  Among other things, the Report points out that the web of interdependencies related to OTC derivatives between the market-making dealers means that disruptions at one such dealer may easily be transmitted to others, as well as to the wider financial system.

The Report then discusses the three phases of the post-trade processing of OTC derivatives: (i) pre-clearing, (ii) clearing and (iii) settlement.  The pre-clearing phase mainly involves trade confirmation and matching services.  The Report notes that, according to recent data, approximately 50% of OTC derivatives continue to be confirmed on paper.  The profound spike in volume of these trades has resulted in delays in confirming transactions which, in turn, has weakened the enforceability of trades, hampered the ability of trade counterparties to net their exposures and increased the risk of incorrect book-keeping (which could lead to an incorrect measure of counterparty credit risk).  The Report further notes that OTC derivatives are still predominantly cleared through bilateral arrangements, as opposed to centrally.  Finally, the Report discusses the predominant existing methods of periodic settlement for OTC derivatives.

The Report notes that there have been numerous recent industry efforts in the area of electronic trade processing and matching services.  It also acknowledges that the urgent push by regulators and market participants to establish central clearing counterparties, particularly for the credit default swap market, has led to progress in the development of such entities.  However, it concludes that the market coverage of existing post-trading infrastructure for OTC derivatives is by no means comprehensive.

In sum, the Report findings highlight the systemic relevance of the OTC derivatives market owing to its size and to the central role of major financial institutions in its trading activities.  The findings also underscore the importance of the euro currency in these transactions and the significant share of market participants located in the euro area.  The Report concludes that its findings point to two main policy implications: (i) the importance of developing post-trading infrastructure to support the safe, efficient and transparent functioning of the OTC derivatives markets and (ii) the need to accompany the development of post-trading infrastructure for OTC derivatives with close cross-border cooperation among the relevant competent authorities.

ISDA Announces Results of Mid-Year 2009 Market Survey

The International Swaps and Derivatives Association, Inc. ("ISDA") announced the results of its Mid-Year 2009 Market Survey (the "Survey") of privately-negotiated derivatives at its regional conference in New York City on September 15, 2009.  The Survey results indicated that the notional amounts outstanding over the past six months of interest rate derivatives increased by 3% to $414.1 trillion, of equity derivatives remained flat at $8.8 trillion and of credit derivatives decreased by 19% to $31.2 trillion.  Each of these products has seen a decline in notional amounts outstanding over the past year by 11%, 26% and 43%, respectively.

The Survey cautioned that the notional amounts outstanding reflected only approximate market activity, not risk.  It also pointed out that, as of December 2008, according to the Bank for International Settlements, the gross market value (i.e., the cost of replacement) of all derivatives was approximately 5.7% of outstanding notional amount and the net credit exposure (i.e., after netting of exposures but before the application of any collateral) of all derivatives was approximately 0.80 percent of outstanding notional amount.  Applying these percentages to the total notional amount outstanding of $454.1 trillion for the trade types covered by the Survey results in a gross mark-to-market value of $26 trillion and a net credit exposure of $3.8 trillion.  The Survey results were based on responses from ISDA's "primary membership": 86 firms provided responses on interest rate derivatives, 77 firms provided responses on equity derivatives and 78 firms provided responses on credit derivatives.

Footnotes