Originally published September 18, 2008

Keywords: Lehman, Fannie Mae, Freddie Mac, Tembac, AIG, derivatives market, bankruptcy filings, LBHI, LBHI subsidiaries, bankruptcy protection, Master Agreements, OTC, Barclays, Credit Event Notice, swaptions

There is a great deal of activity in the derivatives markets, with significant ramifications for managing derivatives exposure. The following presents an overview of the current issues relating to Lehman, Fannie Mae and Freddie Mac, Tembac and AIG.

Lehman

Lehman Brothers Holdings Inc., (LBHI) the ultimate parent entity for the Lehman group, filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code. The US filing did not include any LBHI subsidiaries. Where market participants have Master Agreements in place covering OTC derivative transactions with one or more Lehman group entities, they should determine whether an event of default has occurred with respect to their counterparty. Depending on the terms of such transactions, an event of default may have occurred as a result of the bankruptcy filing where LBHI has been designated as a credit support provider or specified entity. Many derivatives contracts entered into by LBHI subsidiaries were covered by a guarantee issued by LBHI. Accordingly, those trades are likely to have experienced events of default. On the other hand, many of the derivative transactions entered into by LBHI's broker dealer, Lehman Brothers Inc. (LBI), were not guaranteed by LBHI. Those trades, therefore, may not be in default as a result of LBHI's bankruptcy filing.

For trades that have experienced defaults, depending on the terms of the relevant documentation, and notwithstanding the bankruptcy filing, the non-defaulting party may be entitled to close out their trades and (taking into account any posted collateral) determine the net amount owing between them and their Lehman counterparty. However, a non-defaulting party should carefully considering whether terminating a trade would be in its best interest if the non-defaulting would actually owe a close out amount to its Lehman counterparty.

On September 17, 2008, Barclays announced an agreement to acquire LBHI's North American investment banking and capital markets businesses. The sale is subject to approval of the bankruptcy court and other relevant regulatory approvals. Under bankruptcy procedures, such sales would normally take place over a 30 day period. However, LBHI is seeking approval from the bankruptcy court to complete the sale before the end of the week. On a procedural level, this is unprecedented.

In connection with the sale, LBHI is expected to consent to the commencement of a case under the Securities Investor Protection Act (SIPA) with respect to LBI, its broker dealer. A SIPA proceeding could affect the rights of parties with derivative contracts in place with LBI. Among other things, the SIPA trustee could restrict the rights of the LBI's counterparties to terminate or close out trades.

In the case of credit derivative transactions in which a Lehman group entity is a reference entity, ISDA is expected to hold an auction for covered credit derivative transactions (a "Protocol"). The purpose of the Protocol is to offer market participants an efficient way to address the settlement issues relating to credit derivative transactions referencing certain LBHI entities. The Protocol will offer institutions the ability to amend their documentation for various credit derivatives transactions in order to utilize an auction to be scheduled for determining the final price for LBHI covered obligations. Such obligations will be identified at a future date. The process will follow the usual timeline, involving market participants in all the stages that normally apply in effecting a Protocol.

Market Participants who executed the LBHI Uniform Settlement Agreement have already agreed that a Credit Event Notice and a Notice of Publicly Available Information has been delivered with respect to credit derivative transactions with an effective date on or prior to September 15 and a trade date before October 15, under which LBHI is a reference entity (or incorporated in the applicable credit index). However, a Uniform Settlement Agreement is a separate document from a Protocol, and parties wishing to settle via the upcoming Protocol will still need to adhere to such Protocol when the adherence period opens. Signing or not signing the Settlement Agreement will not affect a party's ability to adhere to a Protocol.

As is the case with other Protocols, it is expected that parties electing not to participate in the LBHI Protocol, would retain the right to bilaterally settle their trades with their counterparties. Both parties to a trade must agree to participate in a Protocol to take advantage of its auction mechanics.

Fannie and Freddie

On September 8, ISDA announced that it will launch a Protocol to facilitate settlement of credit derivative trades involving Fannie Mae and Freddie Mac, the US government sponsored entities that went into conservatorship, effective Sunday, September 7.

ISDA also announced that, with the input of a steering committee of market participants, it will compile a list of deliverable obligations for purposes of smooth settlement process in relation to Fannie and Freddie. On September 16, ISDA further announced that, after consulting with ISDA members and with its counsel, the principal-only component of debt securities issued by Fannie or Freddie will not be included in the list of deliverable obligations for purposes of the settlement Protocol.

Tembec

ISDA previously announced a Protocol for Tembec Industries Inc. (Tembec), a unit of Tembec Inc. that filed a Chapter 15 petition in the United States on September 4, 2008. Tembec is a forest products company that is included in various CDX credit derivative indices and is also the subject of single name trades and other credit derivative transaction types. The Tembec Protocol auction is scheduled for October 2, 2008. Markit Group Limited and Creditex Securities Corp. will administer the auction. Market participant have until 5:00 p.m. New York time on Monday, September 22, 2008, to elect to participate in the Tembec Protocol. Parties wishing to participate must submit to ISDA by email an Adherence Letter prior to the cutoff time.

The Tembec Protocol covers single and index credit derivative transactions referencing Tembec, as well as constant maturity swaps, principal only transactions, interest only transactions, first to default transactions, nth to default transactions, recovery lock transactions, bespoke portfolio transactions, single-name swaptions and portfolio swaptions. Reference obligation only transactions, loan only transactions, preferred CDS transactions and fixed recovery transactions are not covered under the Tembec Protocol.

AIG

On September 16, the Federal Reserve Board authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under Section 13(3) of the Federal Reserve Act. The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG is expected to sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

The impact of this transaction on the credit derivatives market is still being analyzed. It is too early to determine whether the Fed's action triggered defaults under any of these transactions or constitute a credit event under CDS referencing AIG entities. The credit rating down-grades recently experienced by AIG may have triggered collateral delivery obligations or other rights on the part of AIG's derivatives counterparties.

Learn more about our Credit Market Distress Team.

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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