District Judge Rules Section 562 Does Not Apply to Terminations by Agreement

Section 562, which fixes the time for measuring damages arising from the termination of securities contracts, does not apply when termination occurs by mutual agreement between the debtor and the creditor, according to District Judge Ronnie Abrams in New York.

The dispute arose in the bankruptcy of Lehman Brothers Holdings Inc. and its domestic and foreign affiliates. The holding was simple, but the facts were confusingly complex.

Basically, Lehman’s U.K. subsidiary was the prime broker for a hedge fund. By contract, the broker could receive margin loans and take short position in its account with the U.K. subsidiary, which held securities for the hedge fund.

The Lehman parent in the U.S. guaranteed the obligations of the U.K. subsidiary.

The Lehman parent and the U.K. subsidiary initiated bankruptcies on the same day in September 2008. The parent was in chapter 11 in New York, while the U.K. subsidiary was in administration proceedings in London. The hedge fund filed a timely claim in the parent’s chapter 11 case. The parent ultimately confirmed a chapter 11 plan providing a percentage distribution to creditors like the hedge fund.

In 2012, the U.K. subsidiary and the hedge fund reached a settlement netting out the value of securities that the U.K. subsidiary was holding for the hedge fund against the hedge fund’s short positions and margin loans.

On the bottom line, the settlement called for the hedge fund to pay the U.K. subsidiary $30 million, according to Judge Abrams’ September 30 opinion.

Under U.K. law, the settlement was based on the $102 million market value of the securities the hedge fund held in its Lehman account at the time the agreement became effective. The same securities were worth about $118 million at the commencement of the Lehman bankruptcies.

In bankruptcy court in New York, the hedge fund made a claim on the parent’s guarantee, claiming that the parent owed the difference between $118 million and $102 million. Based on Section 562, among other theories, the bankruptcy judge in New York sustained Lehman’s objection to the claim.

Judge Abrams reversed.

Section 562(a) provides that if a debtor “rejects” a securities contract, or if a “financial participant” like a hedge fund “terminates” a securities contract, “damages shall be measured as of the earlier of — (1) the date of such rejection; or (2) the date or dates of such . . . termination . . . .”

Without alluding to whatever rights to terminate the hedge fund had under U.S. or U.K. law as the result of bankruptcy, Judge Abrams said that Lehman had a contractual right to terminate but the hedge fund did not.

In bankruptcy court, Lehman contended that Section 562 kicks in regardless of the nature of termination, making the measurement date when the settlement agreement became effective and the securities worth less.

Judge Abrams disagreed. Conceding that Section 562 “does not explicitly compel this conclusion, she said the “termination that occurred was not of the sort contemplated” by the statute. The “lack of clarity,” she said, resulted in part from the absence of a definition of “termination” in the Bankruptcy Code.

The “natural interpretation” of the “plain language” in Section 562, Judge Abrams said, “is that the statute calculates damages resulting from termination as opposed to a situation such as the one here, where the termination represents an amicable settlement of damages pertaining to a breach.” She “bolstered” her conclusion “by the statute’s apparent failure to contemplate a termination that comes about by mutual agreement.”

Judge Abrams drew further support from Section 562’s placement in Subchapter III of Chapter 5, providing various safe harbors for securities contracts. Considering the context, she said it is “abundantly clear” that “when that statute specifies the method for calculating damages in the event of contract termination, it is not a reference to a mutual agreement settling purported breaches but instead a right of the contract signatories to terminate it under certain conditions.”

Any other conclusion, she said, would “fail to effect the policy scheme apparently contemplated by Congress.”