J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov

1. DISTRESSED INVESTING 2011TRADING AND VALUING DISTRESSED DERIVATIVES November 28, 2011 J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov

2. TOPICS • Introduction • CDS on Sovereign Debt: Will it Pay? • The Lehman Valuation Framework • Enforceability of Noteholder Payment Priority on Default: the “Flip Clause” • MF Global Update

3. Introduction • What is a derivative? • a financial instrument derived • from an underlying asset (reference asset) • Key Concepts • Swaps • Valuation • Posting of Collateral • ISDA Documentation • US Bankruptcy Safe Harbor

4. Introduction – Credit Default Swaps • Credit default swaps (CDS) are derivatives which pay on default = credit insurance • Reference obligation is the underlying debt • Per ISDA documentation: the insurance only pays on a triggering event, such as a credit default • If the CDS is triggered, the protection buyer gets cash and delivers (swaps) the underlying debt to its swap counterparty

5. Sovereign CDS • Outstanding Sovereign CDS (Net Notional in USD 11/18/11) • France $24.1B • Italy 21.2 • Germany 19.5 • Brazil 17.6 • Spain 16.9 • Greece 3.4

6. Sovereign CDS Documentation • Q: What are the ISDA terms for a sovereign CDS? • A: “You will need to look at several documents together for that answer (it is not in a single document per se). • Will also vary by sovereign. • Good 1st start is to go to the “ ISDA Credit Derivatives Physical Settlement Matrix and Confirmation (Most Recent Version October 2011)". You will get an excel spreadsheet - click on the tab marked "Sovereigns" and there you will see the ISDA standard terms for various sovereign issuers. To make sense of those terms, you will need to look at the 2003 ISDA Credit Derivatives Definitions, as modified over the past 8 years or so through various supplements and protocols. • Wish I could tell you it was easier . . .” Source: 11/23/11 email from Andrew Cross of RS

7. Sovereign CDS • A Credit (Triggering) Event includes: • Failure to pay • Repudiation/Moratorium • Restructuring: • includes haircut, payment deferral, subordination, change in currency • must occur in a form that binds all holders of the ‘restructured debt’

8. Sovereign CDS • Per ISDA (10/27/11 Update): • Credit Events are determined by a regional ISDA determination committee (DC) • The question will be submitted to the Euro DC when ripe; it will weigh the publicly available evidence and vote on whether a Credit Event has occurred • All firms entering into ISDA CDS transactions have agreed to be bound by the determination

9. Lehman Valuation Framework • A comprehensive solution for all counterparties: “rough justice” • Contrary to the ISDA, the defaulting counterparty set the parameters • Reluctance to admit that bid-ask is part of the claim • No supporting data provided for the framework • One size for all counterparties no matter how big or small

10. Lehman Valuation Framework Tables of “Add on” spreads for each major category of instrument, e.g.: • Swap spreads by maturity and currency • Volatility spreads for options • Credit spreads for CDS • Liquidity spreads for large size positions • Spreads for complexity

12. The Flip Clause • Dante CDO (structured by Lehman) sold CDO notes to investors (noteholders) for cash; the notes were rated AAA • The CDO held the cash in trust as collateral for the CDO notes but entered into a credit default swap with Lehman which provided for various payments off the top to Lehman • If the swap terminated due to Lehman’s default, the CDO notes became due and the cash in the trust would repay the notes and thereby cut off payments to Lehman • This “waterfall flip” was to take effect if the swap termination was caused by Lehman’s default • If the swap terminated for other reasons, there was to be a substantial up-front payment to Lehman that would materially impair the CDS notes

13. The Flip Clause • The documents were governed by UK law • The noteholders sought to terminate their swap before Lehman filed in the US and be paid the cash collateral underlying the swap based on the waterfall flip; UK courts agreed and upheld enforcement of the flip • Lehman asked US Bankruptcy Court to invalidate waterfall flip, ignore UK ruling, and direct BNY to distribute substantial cash to Lehman

14. The Flip Clause • Bankruptcy Court invalidated subordination of Lehman’s swap claim against the Dante CDO: • held: a waterfall “flip” is not enforceable when it is triggered by the bankruptcy filing of either the swap counterparty or its credit support provider • void as an ipso facto clause • ipso facto applied retroactively to bankruptcy filing of swap counterparty or related entity • US bankruptcy law governed the matter despite UK choice of law clause in documents

15. Flip Clause – Why should You Care? • Can’t rely on waterfall flip even if it is in your contract • Bankruptcy Court can retroactively determine that automatic stay and ipso facto prohibitions apply before the Ch 11 filing of your counterparty – as long as a related entity filed before termination • Where swaps are part of a complex transaction, a Bankruptcy Court may review and interpret a swap independently from related transaction documents

16. MF Global Update $ $ $ In the wee hours of Monday October 31, 2011 MF Global filed its bankruptcy case in SDNY – and $1.2B of customer money is missing? 2011

17. MF Global Update • Parties: • Louis Freeh, Bankruptcy Trustee • James Giddens, SIPC Trustee • CFTC

19. Written Materials • Greek Sovereign Debt Q&A page 1 - ISDA Update 10/27/11 (excerpts) • Derivatives Claims Settlement Framework page 5 - May 27, 2011 Legacy Asset Management Co, • Letters to the Lehman Court re Settlement Framework, SDNY Bk Case # 08-13555 page 49 - JP Morgan, October 4, 2011, D.I. 20580 page 52 - Citibank NA, October 4, 2011, D.I. 20570

20. Written Materials • Bankruptcy Court “Flip Clause” Decision page 54 - SDNY Bk Case No. 09-02142 D.I. 86 • District Court Decision Granting Appeal page 79 - SDNY Bk Case No. 09-02142 D.I. 117