The court ruling handed down early this week in U.S. Bankruptcy Court in New York on Lehman’s swap termination could have ratings implications for U.S. structured finance transactions that include swap agreements.  

Moody’s Investors Service said that decision may have profound effects on structured finance transactions because it challenges long-held assumptions relating to the subordination of swap termination payments to a swap counterparty following a swap counterparty bankruptcy.  The rating agency said is in the process of determining which of its rated transactions include similar provisions and that therefore could be affected by the decision.  

In the January 25, 2010 ruling, Judge James Peck, the judge overseeing the Lehman Brothers bankruptcy proceedings, held that the market-standard assumptions relating to the subordination of swap termination payments owed to a swap counterparty following a swap counterparty bankruptcy are unenforceable under the U.S. Bankruptcy Code. 

This ruling contradicts earlier decisions of U.K. courts in the same case and raises the specter of uncertainty in applying subordination provisions to swap termination payments where the swap counterparty is a U.S. Bankruptcy Code eligible entity.  Moody"s believes this ruling may have far-reaching implications for structured finance transactions; however, the impact on each security will depend on multiple factors and requires deliberate and case-specific analysis.

The program documentation, governed by U.K. law, provides that payments to the swap counterparty normally precede those to noteholders.  But in the case of a default by the swap counterparty due to any default including bankruptcy, the documents provide that payments will be made to the swap counterparty only after noteholders have been paid in full.

According to Judge Peck, these subordination provisions constituted "ipso facto" clauses void under the Bankruptcy Code.  As used in the U.S. Bankruptcy Code, ipso facto clauses are those that seek to modify the relationship of contracting parties due to the filing of a bankruptcy petition.  Judge Peck further held that subordination provisions are not covered by the special, broad "safe harbor" bankruptcy exemption for swaps.

Moody’s said it is yet uncertain whether an appeal of the decision may occur or would be successful.  A status conference is scheduled on or about February 10, where discussions to attempt to harmonize the conflicting decisions of the U.S. Bankruptcy court and U.K. courts may take place.   

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