On December 19, 2013, the US Bankruptcy Court for the Southern District of New York issued a ruling in Michigan State Housing Development Authority v. Lehman Brothers Derivative Products Inc. (In re Lehman Brothers Holdings Inc.) that extends the safe harbor for termination, acceleration and liquidation of swap agreements under section 560 of the Bankruptcy Code to the settlement calculation provisions of the ISDA® Master Agreement (ISDA Master). (Bankr. S.D.N.Y. Dec. 19, 2013).

The close-out and liquidation provisions of Section 6 of the ISDA Master permit a non-defaulting party to a transaction entered into under that ISDA Master to terminate the transactions and liquidate the positions and posted collateral under the agreement upon a counterparty default, including a bankruptcy default. It is well-established that these termination and liquidation provisions, which would otherwise be unenforceable in bankruptcy, are protected under the section 560 safe harbor. However, this ruling clarifies that the section 560 swaps safe harbor extends to provisions that specify the methodology and procedure for calculation of the value of terminated positions under the agreement, and final amounts owing from one party to the other, even where the settlement calculation provisions themselves would otherwise operate as prohibited ipso facto clauses under Bankruptcy Code section 365(e)(1).

On May 10, 2000, Lehman Brothers Derivative Products Inc. (LBDP) and the Michigan State Housing Development Authority (MSHDA) entered into a 1992 ISDA Master, under which the parties would eventually enter into 20 interest rate swap transactions through July 10, 2008. Additionally, the parties entered into a Schedule to the ISDA Master (ISDA Schedule), which listed certain additional termination events (ATEs) under the agreement (similar to events of default), including a bankruptcy by LBDP's parent, Lehman Brothers Holdings Inc. While the parties specified in the ISDA Schedule their agreed method for determining any termination payment upon the occurrence of an event of default under the ISDA Master (the Market Quotation Method, as detailed under Section 6(e) of the 1992 ISDA Master), the occurrence of an ATE under the agreement required a different method of calculating amounts owed under the transactions (referred to as the "Mid-market Method").

On September 15, 2008, LBHI filed a petition under chapter 11 of the Bankruptcy Code, triggering the ATE. Instead of terminating the interest rate swap transactions under the ISDA Master, the parties agreed to assign the ISDA Master and ISDA Schedule to LBDP affiliate Lehman Brothers Special Financing Inc. (LBSF) and to amend the settlement provisions of the ISDA Master to provide that:

On October 3, 2008, LBSF filed its own chapter 11 bankruptcy petition, defaulting under Section 5(a)(vii) of the ISDA Master. Shortly thereafter, MSHDA:

LBSF disagreed with the method used to determine the amount owed under the terminated swaps and argued that the Mid-market Method should have been used instead, which would have resulted in a termination payment from MSHDA to LBSF of $59,401,019.

In this adversary proceeding, LBSF asserted that the amendment to the settlement provisions agreed upon by the parties in connection with the assignment of the ISDA Master from LBDP to LBSF, which required use of the Market Quotation Method upon LBSF's bankruptcy, operated as an invalid ipso facto clause under section 365(e)(1) of the Bankruptcy Code because it deprived the debtor of a right to property based solely on its bankruptcy filing. MSHDA argued that the amended settlement calculation methodology was protected under the Bankruptcy Code section 560 safe harbor for swap agreements.

Section 560 states that no provision of the Bankruptcy Code may limit the contractual right to cause the liquidation of a swap agreement, but does not indicate whether the contractual method of liquidation is protected along with the right to cause the liquidation. However, the Court held that the contractual method of liquidation was safe harbored under section 560 because it is inextricably linked to the safe harbored provision that provides for the right to cause the liquidation. The Court found that the settlement methodology provided in the amended ISDA Master was therefore exempted from the prohibition on ipso facto clauses under Bankruptcy Code section 365(e)(1).

The Court began by examining the plain language of section 560 of the Bankruptcy Code, which states that the "exercise of any contractual right ... to cause the liquidation ... shall not be stayed, avoided or otherwise limited." Using a dictionary definition of "liquidation" ("to determine by agreement the exact amount of something that otherwise would be uncertain"), the Court concluded that the right to cause a liquidation must include the right to determine the exact amount due and payable as a result of that liquidation. Since the exact amount due and payable under the swap agreement could only be determined by reference to the methodology specified in the swap agreement, the methodology was an essential part of the act of causing the liquidation.

LBSF urged the Court to adopt a narrower interpretation, arguing that only the right to cause the liquidation was protected, but the method by which the settlement amount is calculated is an unprotected ancillary right. The Court did not find this argument persuasive, holding that:

The court went on to distinguish the facts and circumstances of this case from other cases cited by the Lehman parties, including:

However, the Court held that because the right to choose the method of liquidation is inextricably linked to the right to cause the liquidation and is not merely an incidental or ancillary right, the method of liquidation is protected by the section 560 safe harbor covering swap agreements.

While the prohibition on ipso facto clauses is well established, provisions that facilitate settlement of an outstanding swap transaction upon a counterparty's bankruptcy will be upheld under section 560 of the Bankruptcy Code. Moreover, portions of those clauses that are intertwined with the actual liquidation, such as the method for determining liquidation amounts, will also be enforced.

Practitioners should be aware that the settlement calculation provisions of their ISDA Master Agreements will be protected if their counterparty enters into bankruptcy, even if these provisions have been modified by subsequent amendment to deprive the counterparty of rights or payments based on its bankruptcy filing.

For details on early termination under ISDA Master Agreements, including settlement and close-out methodology and calculation of the early termination payment under Section 6(e), see Practice Note, The ISDA Master Agreement: Early Termination.

For more information on the Bankruptcy Code section 560 safe harbor for swap agreements, as well as Code safe harbors for other types of financial contracts, see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist.