The Judge overseeing the bankruptcy proceeding of Lehman Brothers Holdings, Inc. and its affiliates (collectively "Lehman Brothers") recently approved Lehman Brothers’ proposed procedure for settlement or assignment of derivative contracts that Lehman Brothers entered into prior to filing for bankruptcy. (Order available at Lehman-Docket.com, Docket # 2257.) Under the procedure, Lehman Brothers will be permitted to terminate or assign all outstanding derivative contracts without obtaining express approval from its counterparties and without seeking individual approval from the court. Counterparties to existing derivative contracts with Lehman Brothers face the possible imminent loss of both the right to terminate the contracts and the right to expressly consent to assignment of the contracts.
At the time of its motion to establish the procedure, Lehman Brothers estimated that prior to filing for bankruptcy it was party to approximately 930,000 derivative contracts with various counterparties around the world. Lehman Brothers estimated that 733,000 of those contracts had been terminated by the counterparties as a result of the bankruptcy filing. While reserving its right to challenge the validity of those terminations, Lehman Brothers proposed a system for handling all remaining derivative contracts. Lehman Brothers’ motion drew over 100 objections from counterparties, noting, for instance, that the proposed procedure did not require Lehman Brothers to identify the intended assignee prior to assignment and lacked other protections for counterparties. Lehman Brothers responded by proposing a revised procedure with greater protections for counterparties.
Under the revised procedure approved by the Court on December 16, 2008, Lehman Brothers can assign any existing derivative contract without prior consent of its counterparty by sending notice to the counterparty at least 10 business days before the assignment (20 business days if the derivative contract consists of 100 or more transactions). The notice must identify potential assignees and their guarantors, provide information on the ability of the potential assignees to perform under the contract and provide the amounts proposed to be paid by Lehman Brothers to cure any existing defaults under the contract (the "Cure Amount"). A counterparty receiving such a notice will have 10 business days to deliver a written objection to the assignment of the derivative contract (20 business days if the derivative contract consists of 100 or more transactions). The permissible objections are limited to the issues of 1) the proposed Cure Amount; 2) the need to cure a default or early termination event other than insolvency or bankruptcy of Lehman Brothers; 3) the proposed assurance that the assignee will perform; 4) a prior termination of the derivative contract; and 5) the identity of the assignee or guarantor.
If Lehman Brothers does not receive an objection by the expiration of the objection period, the counterparty is deemed to consent to 1) the assignment of the derivative contract; 2) the proposed Cure Amount; 3) the proposed adequate assurances of future payment; and 4) the waiver of its right to terminate for any default prior to assignment, including any defaults unrelated to Lehman Brothers bankruptcy. Lehman Brothers then has a 60 day window to assign the contract. At the time the assignment is consummated, the counterparty loses its right to terminate the contract for any existing condition of default. Following the consummation of the assignment, Lehman Brothers is required to send the counterparty a notice of the effective date of the assignment. At that time, a counterparty may only object to the Cure Amount; however, the objection will not undermine the assignment, it simply gives the counterparty an administrative expense priority claim against the Lehman Brothers bankruptcy estate.
The Lehman Brothers procedure significantly impacts provisions in derivative contracts that require a counterparty's consent to any assignment of the contract. However, the procedures approved by the court apply only to derivative agreements that have not been validly terminated prior to Lehman Brothers' attempt to assign or terminate them. Thus, a counterparty to a derivative contract with a Lehman Brothers affiliate should carefully examine the existing contract and consider whether early termination and/or replacement of the contract is appropriate. This is true even for contracts that Lehman Brothers could be expected to terminate, as counterparties could stand to gain significant control over the timing of the termination and calculation of any payments due upon termination by electing to terminate before Lehman Brothers decides to terminate.