More lessons from the Lehman Bankruptcy: Setoff rights for swap counterparties

June 28, 2013 Ashoke Prasad

As noted last week, litigation stemming from the Lehman bankruptcy continues to impact the understanding of rights and remedies available under ISDA agreements in events of counterparty default or termination. This post looks at another series of recent Lehman cases in which the Southern District of New York concluded that counterparties could not retain collateral from pre-bankruptcy Lehman deposits to ‘set off’ against other amounts that Lehman owed at the time of filing.

For example, In re Lehman Brothers Inc (458 B.R. 134 Bkrtcy S.D.N.Y. 2011) involved a series of foreign exchange swap agreements for which Lehman’s filing resulted in a termination event under the relevant ISDA Master Agreement; at the time of termination, the non-defaulting counterparty held approximately $21 million that Lehman had posted on the agreements at various points prior to its bankruptcy filing per the terms of the applicable Credit Support Annex.

In ruling that the non-defaulting counterparty and its affiliates could not retain that Lehman collateral to set off against other amounts that Lehman owed at termination, the SDNY highlighted that while the non-defaulting counterparty and its affiliates could potentially claim setoff rights under Section 5(A) in the Schedule to the ISDA Master Agreement; under certain sections of the Federal Bankruptcy Code; and under New York state law, they would have to first seek relief from the Automatic Stay that had been triggered by Lehman’s filing. It noted:

“The Bankruptcy Code expressly prohibits exercising a setoff without first seeking relief from the automatic stay (counterparty) failed to seek stay relief while it has been holding the Remaining Collateral. Even though the setoff issue constitutes a good faith legal dispute, (counterparty) is exercising control over property of the estate in violation of the Stay (and) is directed to return the Remaining Collateral to the Trustee without further delay”

In re Lehman Brothers Holdings, Swedbank AB v Lehman Brothers Holdings (445 B.R. 130 S.D.N.Y. 2011)  and In Re Lehman Brothers Holdings, Bank of America v Lehman Brothers Special Financing (439 B.R. 811 ) similarly involved agreements under which Lehman’s filing constituted events of default; in both cases, the SDNY ruled that the respective counterparties could not, on Lehman’s default, retain deposits that Lehman had posted with them in various trading and clearing accounts under the relevant ISDA Masters to set off against other amounts Lehman owed without specifically being granted Automatic Stay relief.  In Bank of America, the court further suggested that certain ‘special purpose’ deposit accounts may not be eligible for setoff where the relevant security agreement authorizing the accounts expressly limited the use of funds in those accounts to providing overdraft protection for Lehman’s daily banking activities, and where circumstances indicated that the accounts had been collateralized by Lehman in response to concerns about its tenuous financial situation in the months just preceding its bankruptcy filing. It noted:

“The Court concludes that (the language of the security agreement) is consistent with the clearly expressed intentions of the parties to collateralize an identified overdraft risk. Accepting BOA’s proposed construction would effectively leave BOA with an unlimited right of setoff with respect to all manner of indebtedness notwithstanding the fact that the agreement was entered into for the stated purpose of securing any Indebtedness that might arise solely in respect of overdrafts. This account was created in response to urgent demands made by BOA…and not to provide BOA with collateral to secure all of its Lehman-related exposure. The purpose is unmistakably clear—to provide incremental security to BOA for a specific, well-defined overdraft risk, not a general cash collateral account.”

As with the cases below, the sheer magnitude of the Lehman filing adds a unique element to the facts that were at issue here, but in an environment in which risk management require practitioners to anticipate any number of potential ‘worst case’ scenarios, certain points are instructive. Even where setoff rights may be interpreted from ISDA agreements, the Federal Bankruptcy Code, and state law, certain types of counterparty accounts may be structured in a fashion that reflects that they were never intended to be set off against other amounts in the event of bankruptcy.

Furthermore, non-defaulting counterparties holding collateral could see their own positions affected significantly by obligations to immediately transfer that collateral to a trustee upon a defaulting counterparty’s bankruptcy filing. Given the complexities of fund and account structures that are required to support large scale trading operations, these will likely remain areas of bankruptcy law and collateral management that demand the focus of practitioners; the space will continue to track similar types of case developments as they occur.

By Ashoke Prasad, Esq., CPA, Assistant Vice President, Litigation Solutions

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1 Comment Leave a Comment

  • 1. Laksmi Panth  |  July 6, 2013 at 2:39 pm

    Nice posting. Thank you for sharing with us. Personally I like it.

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