Commentary: Five Lessons from the Municipal Derivatives Litigation Front

Pre-financial crisis, interest rate derivatives were widely recognized as a valuable part of the municipal issuer’s financial toolkit.  Post-crisis, they have been a thorn in the side of many issuers, resulting in expensive litigation with failed swap providers – most notably the Lehman and Ambac derivatives trading subsidiaries – and public criticism of municipal issuers said to have fallen prey to more sophisticated providers.  There are several lessons to be learned from the recent spate of litigation, which Orrick covered in an article recently published in The Bond Buyer.

Lehman Derivative Litigation Still Looms Large

The market’s attention is fixed firmly on the future of derivatives.  Questions about the implementation and impact of the Dodd Frank requirements, and to what extent the use of swaps in structured finance and other transactions will return, are front and center.  And yet, there are also lessons to be learned from the past use of these somewhat esoteric financial instruments, which continue to be questioned and tested in litigation — with more to come.  Orrick covered this topic in an article recently published in Law360.

UK Supreme Court Confirms the Validity of the ‘Flip’ Clause

In its ruling on July 27 in the matter of Belmont Park Investments PTY Ltd v BNY Corporate Trustee Services Lte & Anor [2011] UKSC 38 the Supreme Court of the United Kingdom has dismissed the appeal by Lehman Brothers Special Finance Inc. For a complete summary of the ruling, please click here.

Rating Agency Developments

On March 17, Fitch released new regional rating criteria for Latin America RMBS, and a Mexican RMBS Addendum, which incorporates an increased data analysis observation period for Mexican RMBS transactions. Fitch Release.

On March 17, S&P updated its methodology for rating unregulated issuers’ hybrid instruments and for classifying the equity content of these instruments. S&P Release.

On March 15, Fitch published its criteria for rating U.S. equity REITs and REOCs. Fitch Release.

On March 15, Fitch published its criteria for rating U.S. mortgage REITs and similar finance companies. Fitch Release.

On March 14, Fitch published a comment that the recent out-of-court settlement between the Lehman debtors and the Dante trustee leaves continuing conflicts of law and uncertainty for cash flow structured finance transactions that have interest and currency rate swaps and “flip clauses”. Fitch Comment.

On March 14, Fitch updated its structured finance counterparty criteria. Fitch Release.

On March 14, Fitch published its covered bonds counterparty criteria. Fitch Release.

On March 14, S&P requested comments on its proposed methodology for rating nonsovereign issuers and structured finance transactions that exceed European Monetary Union sovereign ratings. Comments must be submitted by March 28. S&P Release.

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CalPERS Sues Former Lehman Officers, Directors, and Underwriters for Misstatements and Omissions Related to Subprime and Alt-A Lending

On February 7, 2011, the California Public Employees’ Retirement System (“CalPERS”) filed suit in the Northern District of California against 12 former executive officers and directors of Lehman Brothers Holdings Inc. (“Lehman”) and Lehman’s underwriters, asserting claims under sections 10(b) and 20(a) of the Exchange Act and sections 11, 12(a) and 15 of the Securities Act for losses suffered in its June 2007 through September 2008 investments in Lehman common stock and bonds. The complaint alleges that during that period Lehman did not conduct proper due diligence when it securitized subprime and Alt-A loans and that Lehman failed to adequately disclose risks associated with subprime and Alt-A mortgages. CalPERS also alleges that Lehman failed to adequately disclose risks relating to increased leverage in its investments and that it manipulated its balance sheet by removing debt on a quarterly basis through the use of “Repo 105” transactions. Complaint.

FASB Letter on Lehman Repos

On April 19, the FASB sent a letter to the House Financial Services Committee on selected accounting guidance relevant to Lehman accounting practices.  The letter summarized the current accounting and reporting standards relating to repurchase agreements and consolidation of SPEs and, in particular, discussed Lehman’s Repo 105 and Repo 108 transactions.  FASB Letter.