Background
On November 6, 2009, the English Court of Appeal issued a judgment in the case of Perpetual Trustee Company Limited & another v BNY Corporate Trustee Services Ltd & another [2009] EWCA Civ 1160, an action commenced in the English High Court by the noteholders representative — Perpetual Trustee Company Limited (“Perpetual”). The case concerned a number of collateralized debt obligation (“CDO”) transactions structured and arranged by Lehman Brothers Inc. and its subsidiaries, pursuant to which a number of SPVs (each an “Issuer”) had issued interest-bearing notes (the “Notes”) to investors. At the same time, each Issuer had entered into a credit default swap contract (each a “CDS”) with Lehman Brothers Special Financing Inc. (“LBSF”), with the Issuer as credit protection seller, and LBSF as credit protection buyer.
All of the relevant contractual documentation was governed by English law. LBSF was incorporated in Delaware with its principal office in New York and had filed for Chapter 11 protection on October 3, 2008.
The proceeds of the Notes had been invested and security in the form of fixed and floating charge had been granted in favor of BNY Corporate Trustee Services Limited (the “Security Trustee”), for the benefit of the Noteholders and LBSF (to the extent that amounts would become payable to LBSF as a result of the early termination of the CDS). The security documentation provided that LBSF would have priority over the Noteholders in respect of the Note proceeds unless an event of default occurred where LBSF was the defaulting party (which included the bankruptcy of LBSF or its parent). At the point at which the event of default occurred (LBSF entered into insolvency proceedings in October 20081), the order of priority of distribution of the security therefore changed or “flipped”.
Following the collapse of the Lehman Group, payments due to the noteholders were not made and Perpetual asserted claims against the Security Trustee, seeking orders that the Security Trustee make distributions in their favor and in priority to the claims of LBSF. LBSF did not accept that the noteholders were entitled to priority over LBSF in the security realisations waterfall (of the security trust deed) and asserted a claim in the United States Bankruptcy Court, seeking an order that the provisions under the trust deed were contrary to the “ipso-facto” provisions of the US Bankruptcy Code (see V below).
LBSF’s allegation in the US Bankruptcy Court was heard on August 11, 2009. Prior to this, Perpetual asserted claims in the English High Court against the Security Trustee to procure realisation of the collateral held by the Security Trustee pursuant to the trust deed and its application (i.e., payment to the noteholders in priority to paying the claims of LBSF). LBSF sought a temporary stay of the English proceedings pending resolution of the proceedings in the US Bankruptcy Court. The issue was whether the provision in the Security Trust Deed giving priority to noteholders over LBSF upon the occurrence of an event of default was valid as a matter of English law?
The US and UK Courts had recognised the potential for conflicting judgments from the start of the litigation. On the application of certain noteholders, the English High Court sent a letter to the US Bankruptcy Court which was characterized by the US Bankruptcy Court as follows:
“[T]he English court has confined itself to making a declaration that the relevant contractual provisions are ‘valid, effective and enforceable as a matter of English law as the proper law of such contracts, so as to give effect to Noteholder Priority,” and requested that if the US court were to conclude that “the relevant provisions are void or otherwise unenforceable under US bankruptcy law” it “go no further at that stage than to make a declaratory judgment to that effect.”
The English Proceedings and Anti-Deprivation Principle
The principle of “anti-deprivation” dates back to the 19th century. A long line of cases have, in different ways, expressed a rule that “there cannot be a valid contract that a man’s property shall remain his until his bankruptcy, and on the happening of that event shall go over to someone else, and be taken away from his creditors” (Ex parte Jay (1880)).
The principle operates to support the fundamental rule that distributions in a winding-up must be made to creditors in the same category on a pari passu basis (s107, Insolvency Act 1986 and rule 4.181, Insolvency Rules 1986 (SI 1986/1925)). In essence, the anti-deprivation principle provides that a contractual provision is void if it provides for the transfer of an asset from the owner to a third party upon the insolvency of the owner. Attempts to avoid the anti-deprivation principle have been ruled void as a matter of public policy (British Eagle International Airlines Ltd v Cie Nationale Air France [1975]).
Nevertheless, the application of this principle by courts in numerous cases has given rise to some degree of uncertainty. As the Master of the Rolls himself said in the case: “It is not entirely easy to define the rule’s precise limits, or even its precise nature as the reasoning in the various judgments in which the rule has been considered is often a little opaque, and some of the judgements are a little hard to reconcile.”
In Perpetual Trustee Company Limited v BNY Corporate Trustee Services Ltd, the issue arose as to whether the provision in the security trust deed which gave priority to noteholders over LBSF upon the occurrence of an event of default, fell foul of the anti-deprivation principle.
The Decision
LBSF argued that such a provision in the trust deed that flipped the order of priority of distribution of the security was void under English law as it had the effect of depriving creditors of LBSF of an asset upon its insolvency.
Perpetual responded that the clause was valid and relied on the distinction drawn by the courts between a contract which by reason of the insolvency seeks to remove assets from the estate of the bankrupt and a contract under which the insolvent’s interest in the asset is limited and determined upon insolvency (also referred to as a “determinable interest”). Perpetual contended that LBSF had a determinable interest because, under the terms of the trust deed, LBSF only ever had an interest, in respect of its payment in priority, which determined on an event of default in the event that LBSF was the Defaulting Party. After considering a number of cases where the anti-deprivation principle had been considered,2 the judge concluded (at paragraph 43) that while a provision that serves to deprive creditors of assets upon an insolvency “was contrary to public policy and therefore void, it is also clear that there exists an exception to that principle for the grant of an interest in property determinable on the insolvency of the grantee, but not the grantor. Between those extremes exists an uncertain area... In any given case it is necessary to construe the relevant documents in light of the decided cases.”
The judge had two separate reasons for concluding that the rule did not prevent Perpetual from relying on the flip clause. The first reason was based on the nature of the right triggered by the insolvency event, and essentially turned on the extent of the anti-deprivation rule. But even if the flip constituted a deprivation, the court’s decision relied on a second reason, which was based on the alleged deprivation itself. The anti-deprivation principle was not applicable to a deprivation effected pursuant to the Chapter 11 filing of a different entity.
The judge held that the clause in the trust deed was valid and not contrary to public policy for the following reasons:
- It was not possible to examine the “flip” clause in isolation, but rather the transaction should be analyzed as a whole: the collateral was bought by each Issuer with the note proceeds; it was not derived from LBSF as the swap counterparty;
- It was clear that the intention of all the parties was that priority afforded to LBSF was conditional. The priority of LBSF did not continue after an event of default, where LBSF was the defaulting party; and
- LBSF’s priority security interest in the collateral was always conditional and limited and could not pass to a liquidator free from those conditions and limitations.
The judge also expressed his view on the argument made by Perpetual that the anti-deprivation principle could not apply to LBSF as it was not the subject of an English insolvency proceeding and was only the subject of a Chapter 11 case in the US. On this point, the judge held that it could not be said that the English anti-deprivation principles would only apply in the context of an English insolvency proceeding. Under both common law and/or statute (Cross Border Insolvency Regulations 2006), English courts were obliged to recognise and provide assistance to the US courts and, if necessary, to apply this principle in the context of non-UK insolvency proceedings.
The Appeal
In its judgment, the Court of Appeal unanimously dismissed LBSF’s appeal and upheld the decision of the High Court on the following grounds:
- The anti-deprivation principle only applies to arrangements which take effect at the date of insolvency of the insolvent where the estate is allegedly “deprived” of assets; disposals of assets made prior to the onset of insolvency are not affected, unless caught by specific statutory provisions affecting antecedent transactions; and
- The priority which LBSF had to the collateral as provided by the issuers was contingent on there being no event of default. The effect of the “flip” provision was to vary the order of priorities in which the rights were to be exercised in relation to the proceeds of sale of the collateral (rather than divesting LBSF of assets vested in it and vesting those assets in the noteholders).
LBSF filed a further appeal on March 26, 2010, and the Supreme Court (the highest court in the United Kingdom) has decided to hear the case, with hearings provisionally set for March 2011.
Battle of Bunker Hill?
In the US, ipso facto clauses (provisions in an agreement that would deprive a party of a right as a result of its insolvency or its bankruptcy filing) are generally unenforceable in a bankruptcy proceeding (section 365(b)(2), US Bankruptcy Code). This represents the US equivalent of the English “anti-deprivation” rule albeit the US doctrine is wider than the English principle.
The US Bankruptcy Court for the Southern District of New York (The Honorable James M. Peck) in the parallel proceedings (re: Lehman Brothers Special Financing Inc. v BNY Corporate Trustee Services Limited (Case No: 09-01242) has declined to follow the decision of the English courts and has issued a memorandum decision finding that the “flip” was an unenforceable ipso facto clause. Consequently, the Security Trustee is currently trapped between two contradictory court decisions in two jurisdictions with one telling it to pay the noteholders first and the other telling it to pay LBSF first.
The US court found that the English courts had not taken into account principles of US bankruptcy law and in particular section 365 of the Bankruptcy Code. Judge Peck emphasised that “(US) courts will not extend comity to foreign proceedings when doing so would be contrary to the policies or prejudicial to the interests of the United States.” Despite the challenges posed by conflicting judgments Judge Peck concluded that the US had a sufficiently strong interest in the circumstances to justify and require the application of US bankruptcy law, noting in particular where the relevant provisions of the Bankruptcy Code would provide the debtor with greater protection than that available under English law.
It has been reported that the parties had been directed to appear at a hearing to explore “means to harmonise” the US decision with the English decision, but it has been further reported that this has been postponed pending the outcome of the UK Supreme Court hearing in 2011. Reconciling the US and English approach would appear a first glance to be problematic and one alternative might involve limiting the geographical reach of each judgment to their respective territorial assets. Another option might involve LBSF attempting to have the US judgment recognized in England by means of the UNCITRAL Model Law on Cross-Border Insolvency, which has been adopted by both countries.
Conclusion
The judgment of the Court of Appeal, certainly for the meantime, has limited the scope of the anti-deprivation principle. There also remains no small degree of uncertainty following the judgement of the Court of Appeal regarding the distinction between the grant of a proprietary interest in property which is determinable upon insolvency (and valid) and a provision providing for the transfer of property on terms that it shall be forfeited on insolvency (which is not valid).
Meanwhile, the case is of enormous consequence to all English structured finance transactions (and particularly those which involve U.S. counterparties) that contractually provides for the order of priority of payments to secured counterparties to be changed in certain specified circumstances. It is pleasing to see that the English courts have so far upheld the clear contractual intentions of the parties as determined in the transaction documentation and recognised the noteholders priority. The judgement may also represent a serious challenge for rating agencies when assessing the likelihood of timely or ultimate payment of principal and interest on rated notes