Counterparties to derivatives transactions may think twice about contracting with US-based dealers after an American court handling Lehman's bankruptcy has found that a provision in the master agreement used in most derivatives transactions is unenforceable.
At issue is the way in which creditors treat their claims against an insolvent counterparty -- only a minor concern 18 months ago, but a multi-billion dollar worry today. When Lehman went broke a year ago, counterparties holding 900,000 separate derivatives contracts with the failed bank found themselves in an unusual position.
Some were aggrieved -- they were in the money and winning when Lehman went under, which meant they had to terminate their contracts and line up alongside other creditors. They can now expect to get paid a few cents for each dollar they are owed.
But other counterparties were happy -- they owed Lehman money on loss-making contracts, which were losing more money by the day, and took Lehman's bankruptcy as an opportunity to keep their shirts and walk away.
Not so fast, says the US bankruptcy court. It has found that derivatives counterparties have just two options: either keep the agreement in place and keep paying the premiums or terminate the contract and pay any money owed to the insolvent counterparty.
This is not what Lehman agreed when it contracted with its counterparties. The International Swaps and Derivatives Association (Isda) master agreement governing most derivatives transactions says that a counterparty does not need to make payments if the other party suffers an event of default and, needless to say, bankruptcy is classed as such an event.
The new ruling changes the terms of the game considerably. "Now the derivatives counterparties must assess whether they are better just paying out the termination payment to the insolvent counterparty," said Perry Sayles, a Hong Kong-based US partner at Freshfields Bruckhaus Deringer, an international law firm, "or whether they are better off keeping the agreement in place and continuing to pay the insolvent counterparty, with the hope that it will perform its obligations, which is possible in a reorganisation, or sell its rights and obligations to someone else."
However, the rules of the game are still the same in markets such as Hong Kong and Singapore, which means that counterparties can avoid the consequences of the US ruling by simply trading with dealers based outside the US -- or with dealers that would not be subject to bankruptcy proceedings in the US.
"If there remains a difference as to enforceability, and people care enough about being able to rely on this provision, it could mean that banks shift all of their derivatives operations to London or other jurisdictions," said Sayles, who adds, however, that other concerns also play a big role in determining where a bank chooses to locate itself, such as regulatory and tax issues.
The master agreement will come under the scrutiny of English-law courts in the insolvency proceedings of Lehman's London-based businesses during the next few months and insolvency specialists do not expect them to agree with their US counterparts. The provision has been tested once before in a Commonwealth court, in Australia during the Enron bankruptcy, which ruled that the energy company should be held to the contracts it signed. English courts should follow that ruling.
If that happens and the divergence between US and non-US law persists, derivatives professionals may have to find a solution of their own -- after all, nobody wants to be forced to move their derivatives businesses outside the US because of a discrepancy in the enforceability of a particular provision in the Isda master agreement.
One answer, and the most likely solution, is to work with Isda to amend the agreement itself. Until then, counterparties can enjoy more favourable treatment by contracting with non-US derivatives dealers.