Lehman Contract Is Test Case for Billions of Dollars of Swaps

By Linda Sandler

Aug. 11 (Bloomberg) -- A U.S. bankruptcy judge may have a controlling say in resolving a dispute in a U.K. court between Lehman Brothers Holdings Inc. and a Bank of New York Mellon Corp. unit over a swap agreement that could affect billions of dollars of similar contracts.

At issue is who under U.S. bankruptcy law gets paid first under two swap agreements related to Lehman’s so-called Dante program of credit-linked notes -- Lehman or investors who bought the notes. Lehman lost under U.K. contract law. The U.K. judge left the question of U.S. bankruptcy law open as Lehman appeals his ruling.

“This issue has never been tested in court in the U.S.,” said Guy Dempsey, co-chair of the derivatives group at the law firm Latham & Watkins LLP.

Lehman, the investment bank liquidating in bankruptcy, says it is owed $70 million on the swaps and wants to get paid. BNY Corporate Trustee Services Ltd., acting for the note-holders, wants the case dismissed and cites a U.K. judge who said last month that note-holders are entitled to the payments under U.K. law now that Lehman is bankrupt.

The case, being considered in bankruptcy court in New York today, may affect many other swap agreements designed like Lehman’s, which includes an indenture and a sequence of payments, Dempsey and other experts said.

Terms of the two Lehman transactions, named Dante after the entity that issued the notes, specify that investors have first claim on whatever money is available if Lehman defaults or goes bankrupt. While the U.K.-based contract favors the noteholders, U.S. bankruptcy law normally protects a debtor company’s assets. Lehman is asking the bankruptcy judge to rule in its favor.

Not Yet Tested

Not yet tested is whether U.S. law permits the investors to use a written contract to give themselves priority claims after a bankruptcy. In the U.K., the related case was brought against Lehman by a trustee for Australian note-holders, Perpetual Trustee Co.

Rating agencies could start to downgrade credit-linked notes if the bankruptcy judge says Lehman can take away assets protecting the investments, debt research firm CreditSights Inc. said in a July 12 report. Insulating such deals from bankruptcy “forms the bedrock of securitization, CreditSights analyst Atish Kakodkar said in the report.

Lehman had a similar tussle last month in the U.S. over who owed what to whom with Metavante Corp., a company involved in another swap agreement. U.S. Bankruptcy Judge James Peck, in charge of Lehman’s bankruptcy, said in that case that he believed Lehman should be paid. He postponed a decision until September to give the opponents time to settle the issue themselves, Dempsey said.

Biggest Bankruptcy

Last September, Lehman filed the biggest U.S. bankruptcy ever with assets of $639 billion. It sued Bank of New York on May 20 over payments related to the credit-linked notes, issued by an entity it set up, Dante Finance Public Ltd.

“The bankruptcy code protects debtors from being penalized for filing a Chapter 11 case, notwithstanding any contractual provisions or applicable law that would have that effect,” Lehman said in its complaint.

Lawyers for Bank of New York, Eric Schaffer and Michael Venditto of Reed Smith LLP, didn’t returns calls or e-mails seeking comment.

The adversary case is In re: Lehman Brothers Holdings Inc. v. BNY Corporate Trustee Services Ltd., 09-01242, U.S. Bankruptcy Court, Southern District (Manhattan).

To contact the reporters responsible for this story: Linda Sandler in New York at lsandler@bloomberg.net;