Time is running out for those who are unhappy with the settlements of some 930,000 Lehman derivatives contracts. With the statute of limitations running out on filing Lehman derivatives disputes, a flood of new cases is expected from parties holding these contracts when Lehman filed for bankruptcy in 2008. An article by law firm Orrick Herrington & Sutcliffe LLP lays out some some of the parameters of this potential wave of last minute Lehman litigation.
The bulk of Lehman derivatives contracts were terminated by the counterparties under terms permitted within the agreements within a month or two after Lehman’s bankruptcy filing. But some very significant questions remain about quite a few of the terminations, questions that are worth billions of dollars to Lehman’s bankruptcy estate.
Although amendments to the Bankruptcy Code intended to facilitate the smooth functioning of the financial system following a Lehman-like bankruptcy explicitly safe harbors these kinds of derivatives contracts, according to Orrick, the application of the safe harbor raises a host of new legal questions.
- Did the terminations meet the technical requirements of the governing documents?
- Did the counterparty calculate the correct breakage amount to be paid to (or received from) Lehman?
- Who was entitled to be paid first when structured finance transactions involving swaps were unwound —Lehman, as the bankrupt swap provider, or the investors who funded the transaction and, under typical deal documents, were to be paid first under the priority “waterfall” in the event of a Lehman bankruptcy?
So, what is expected is more litigation on extremely esoteric points concerning these most esoteric instruments. In particular, Orrick says that how to interpret “flip clauses” and how to apply breakage amounts could be major issues for dispute resolution. To date, there has been little or no district court or circuit court guidance on these topics, and their outcomes remain very uncertain.
There are also open questions about the power of the Bankruptcy Court to even rule on derivatives disputes.
Another issue that may take center stage, at least in the bankruptcy context, is whether a bankruptcy court has the right to enter a final order or judgment on a claim for breach of a derivatives agreement —or any other contract.
The jurisprudence strongly suggests that all of these derivatives disputes may have to move to federal district courts to be resolved fully. This could not only add to the complications of these cases, but will add to the cost as well.
In its 2011 decision in Stern v. Marshall, the Supreme Court redefined the scope of the bankruptcy court’s power to enter final orders and judgments. The reasoning in Stern strongly suggests that a bankruptcy court lacks the power to enter a final judgment in a breach of contract case governed by state law, and instead can only make a report and recommendation to the district court. The courts continue to grapple with the implications and scope of Stern, and Stern may significantly impact the contours of derivatives and other contract litigation with bankrupt counterparties.