Lehman Brothers Holdings Inc
The case will decide whether the bank has the first claim on $70 million in assets in a collateralized debt obligation (CDO)-- securities backed by a pool of assets -- or whether investors in the deal have the right to jump ahead of Lehman in being repaid the funds because of the bank's collapse in September 2008.
The case in the United States Bankruptcy Court for the Southern District of New York is being widely watched as it is expected to establish a benchmark for the priority of claims in bankruptcy cases involving CDOs that use derivatives.
Lawyers have estimated an additional $12 billion in claims could be made based on the outcome and judge James Peck acknowledged the case would likely set a precedent.
It is potentially a landmark decision on the treatment of derivative contracts in bankruptcy, and to what extent you can look at things such as protecting investors' original expectations with respect to the transaction, said Robert Claassen, partner at law firm Paul Hastings.
The dispute centers around a credit default swap that Lehman was a counterparty to in a CDO, called Dante. The credit default swap was used to sell protection on a portfolio of debt held in the deal. Payments received from the swap were then passed on to the deal's investors.
A credit default swap, or CDS, is an insurance-type contract used to protect against default risk or bet on the credit quality of an issuer.
The English High Court last month ruled investors in the deal, represented by Australian investment service company Perpetual Trustee Co, had a senior claim to Lehman. The court said terms in the deal allowed the investors to jump ahead of Lehman's claim because its collapse in September 2008 constituted a default.
Lehman, however, argued the case should be tried in the United States because terms of the deal were contrary to the anti-deprivation provision in U.S. Bankruptcy Code.
If the decision is in favor of Lehman, the US Bankruptcy Court would probably ask the English court to cooperate with it and potentially provide assistance to implement its decision, said Neil Hamilton, partner at Clifford Chance in London.
The New York bankruptcy court on Tuesday rejected a motion by the Bank of New York Mellon Corp, which is trustee to the CDO's assets, to dismiss the case. The case is expected to be tried the same day as a similar dispute involving Lehman and insurer Aflac
WIDE RANGING IMPACT
The outcome of the case is expected to have a wide ranging impact on the securitization market, because of the prevalence of derivatives in CDOs. These may include CDSs, total return swaps, interest rate swaps or other derivatives.
It would be an unwelcome surprise to the securitization market if the case were to go in Lehman's favor, said Clifford Chance's Hamilton.
It would invalidate the provision in the priority of payments that the swap counterparty loses its senior priority if it becomes insolvent. This is a common provision in securitizations generally, he said.
The decision could also spark ratings changes.
I think it would certainly cause rating agencies to reassess some securitization ratings because it would mean potentially that there could be a senior priority for swap counterparties even where the counterparty was insolvent and unable to perform, Hamilton said.
Meanwhile bankrupt swap counterparties, including Lehman, are likely to be challenged by a slew of additional claims if the case is found in favor of investors.
In some cases, investors may also look for other instances of default, aside from bankruptcy, in order to void the priority claims of swap counterparties, lawyers said.