January 24, 2011

Split Decisions?

When Lehman Brothers went bankrupt, most of their derivatives counterparties invoked their rights under the ISDA Master Agreement and terminated their trades within a reasonable amount of time, and in the prescribed manner, following the Early Termination process. But some entities did simply…nothing. They never terminated their swaps, nor sought to terminate their swaps, but simply stopped paying on them entirely, as payments are subject to the conditions precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred or is continuing (Section 2(a)(iii)). Back in September 2009, a U.S. court ruled against one of these entities and in favor of Lehman, stating that there are only two choices: either keep paying on the contract or terminate and pay the money owed. The ruling basically left Section 2(a)(iii) of the ISDA Master Agreement in doubt.

We now have split decisions on this very topic, albeit in different jurisdictions (New York and London). During the holidays, a case involving four Lehman counterparties, who stopped paying on their contracts and never terminated, finally worked its way through the English Courts. In this case, the court ruled that the counterparties were well within their rights to suspend payments, unless the Event of Default (Lehman’s bankruptcy) was cured (which, it seems, can’t happen). This meant that the entities did not have to make outstanding swap payments, nor did they have to terminate their swaps, while the Event of Default was continuing. The court further ruled that there is no time limit on the conditions precedent in section 2(a)(iii), nor does it expire at the maturity of the trade. If payments were still suspended at the time the trade reached its original scheduled termination date, then the payment obligation would be extinguished. Although the court ruling currently favors the four end users, the Lehman estate has appealed the decision.

So, what does this mean to you? Even as market participants assess the impact of these differing decisions, many of Lehman’s OTC derivative counterparties in the U.S. are now going through the court ordered arbitration process, and their valuations face challenges. Chatham Financial can help you in this process. Please give us a call if you wish to discuss your valuations or your situation.

Regulatory Update – The Executive Order

President Obama this week issued an executive order that would, in his words, “[make] it our mission to root out regulations that conflict, that are not worth the cost, or that are just plain dumb.” He observed that “regulations do have costs” and that “we have to make tough decisions about whether those costs are necessary.” As we have now for months been engaged in the regulatory rulemaking process, we have a keen appreciation for this Presidential initiative. At the same time, however, we note that the President’s executive order has no force or effect on independent agencies such as the CFTC, SEC and Federal Reserve, who are hard at work writing hundreds of pages of rules delegated to them by Congress as part of financial legislation.

Despite the limited reach of the order, we appreciate its sentiments and are hopeful that they will be taken into account by these agencies. Notably, the order directs federal agencies to “do more to account for – and reduce – the burdens regulations may place on small businesses.” Derivatives regulations explicitly grant authority to the CFTC to do just that. The CFTC has the authority to exempt small banks from the clearing and trading requirements that were principally designed for swap dealers and other major market players. Additionally, limited aspects of Dodd-Frank fall under the domain of the order. The Treasury Department has been granted authority to exempt foreign currency forward contracts from the salient requirements of the law. Chatham joined the Coalition for Derivatives End-Users in asking them to do just that late last year in a letter.

With both the small bank exemption and the FX forward exemption, regulators have the ability to limit the costs thousands of businesses will bear due to Dodd-Frank, while not at all diminishing its worthy effort to contain systemic risk and increase transparency in the derivatives market.

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