Court holds that distributions made pursuant to priority payment provisions contained in CDO transactions are protected by Section 560 of the Bankruptcy Code

On Tuesday, the Bankruptcy Court for the Southern District of New York rendered its much-awaited decision in Lehman Brothers Special Financing Inc. v. Bank of America National Association, Case No. 10-3547 (Chapman, J), the so-called “flip-clause” case. The decision granted the defendants’ motion to dismiss Lehman Brothers’ claims seeking to unwind transfers received by noteholders in connection with certain complex financial transactions. The Bankruptcy Court’s decision clarifies the reach of the Bankruptcy Code’s ipso facto clauses and reconfirms the breadth of the Bankruptcy Code’s safe harbors protecting non-debtor counterparties’ rights to terminate transactions, net close out values and liquidate collateral (including the distribution of the proceeds of such collateral). The decision is also important because, although much of the previous safe harbor jurisprudence focuses on the Bankruptcy Code’s anti-avoidance safe harbors in Section 546, it is one of the rare decisions to consider the safe harbors’ exception from the enforcement of the ipso facto clauses for financial contracts in Sections 555, 556, 560 and 561 of the Bankruptcy Code.

Past Lehman precedent

As discussed below, the Bankruptcy Court’s decision is particularly notable because of its departure in several material respects from two prior Lehman decisions, BNY and Ballyrock, in which the Bankruptcy Court considered similar synthetic collateralized debt obligation (CDO) transactions. In BNY and Ballyrock, the Bankruptcy Court held that:

  1. payment priority provisions that favored LBSF initially but could “flip” to favor noteholders were impermissible ipso facto clauses;
  2. the shift in payment priorities occurred when the collateral underlying the transaction was liquidated, rather than when the swap agreement was terminated;
  3. the September 15, 2008 bankruptcy of Lehman Brothers Holding Inc. (LBHI) and the October 3, 2008 bankruptcy of Lehman Brothers Special Financing Inc. (LBSF) were a “singular event,” permitting LBSF to benefit from the protection of the Bankruptcy Code’s ipso facto clauses beginning on September 15, 2008, even though this date was three weeks prior to its own declaration of bankruptcy; and
  4. the safe harbor of Section 560 permitted the liquidation of the collateral underlying the transactions, but not the distribution of the proceeds resulting from such liquidation.1

Acknowledging the controversial nature of the decisions, a district court granted interlocutory appeal to reconsider these issues, but the appeal was thwarted when Lehman quickly settled with the defendants. This left the BNY and Ballyrock precedents intact for the last six years, causing uncertainty in the marketplace regarding the degree of protection afforded to participants in structured finance transactions in the event of a counterparty’s bankruptcy. Yesterday’s decision will undoubtedly be a much-welcomed development for participants in structured finance markets. In essence, the Bankruptcy Court declined to follow much of the precedents established in BNY and Ballyrock. Moreover, the Bankruptcy Court’s focus on the language of the specific contracts at issue provides participants in structured finance markets with important guidance on how to document such transactions.

The instant litigation

The instant case involved dozens of synthetic CDO transactions structured by Lehman in the years before its collapse. The typical transaction let investors buy notes – whose payments were based on the performance of a reference basket of other securities – from a special purpose vehicle (the Issuer). At the same time, the Issuer sold a credit default swap – based on the same reference entities – to LBSF. If the reference securities performed well, then LBSF would pay amounts to the Issuer pursuant to the swap, and the Issuer would use such amounts to pay investors pursuant to the notes. But, if the reference securities performed poorly, then the Issuer would pay LBSF instead. As the collateral would not necessarily be of sufficient value to satisfy LBSF’s claims under the swaps and the investors’ claims under the notes, the transaction documents provided a payment priority waterfall. Generally, priority would be determined at the time of a default in favor of the non-defaulting party. In some of the transactions, however, LBSF was granted payment priority at the outset, subject to losing that priority upon the occurrence of a condition subsequent, including an LBSF default. This distinction turned out to be important.

On September 15, 2008, LBHI filed for bankruptcy. The bankruptcy of LBHI (LBSF’s parent and credit support provider) meant that LBSF became a defaulting party, giving note investors a priority claim on the collateral. LBSF itself didn’t file for bankruptcy until three weeks later. During that three-week period, many Issuers terminated their swaps with LBSF based on the default caused by LBHI’s bankruptcy filing. In most cases, the collateral was liquidated and distributed to noteholders prior to the occurrence of LBSF’s own bankruptcy filing (a so-called “pre-pre transaction”). In other cases, although termination occurred prior to LBSF’s bankruptcy, liquidation and distribution occurred afterwards (a so-called “pre-post transaction”). LBSF’s swap claims, which were generally in the money, were left with no recovery.

LBSF commenced a defendant class action seeking to invalidate the priority of payment provisions as impermissible ipso facto clauses and to claw back the proceeds of the liquidated collateral paid to the noteholders in both pre-pre transactions and pre-post transactions. After several years of litigation, yesterday’s decision dismissed the claims against the defendants. In so doing, the decision answers several thorny questions for financial market participants.

First, the Bankruptcy Court held that not all priority of payment provisions are impermissible ipso facto clauses. The result turns on a somewhat technical distinction between two types of priority provisions. An impermissible type of priority provision gives LBSF priority in a waterfall from the outset, but deprives LBSF of this priority should there be an early termination based upon an LBSF event of default (including its bankruptcy). A permissible type of priority provision establishes no priority for the swap until early termination occurs. At the time of early termination, LBSF is subordinated only when there is an LBSF event of default (which was deemed by the Court not to deprive LBSF of a right that it had in the absence of bankruptcy). This distinction depends entirely upon the drafting of the priority provisions. In order to manage the risk of a counterparty’s bankruptcy under this rationale, the priority of payment provisions should be drafted so that (1) the payment priority in the waterfall is not varied by a counterparty event of default and (2) counterparty priority is established at the time of early termination so as not to deprive the counterparty of a right it had in the absence of bankruptcy. With respect to agreements that contain an impermissible ipso facto clause, the ruling provides a helpful corollary – any change in payment priority occurs when the debtor is served with a notice of early termination, not at the time that the proceeds of the liquidated collateral are distributed. This provides market participants with some certainty because, although they can often control the timing of the early termination notice, the timing of distribution – particularly at a time of intense market dislocation, such as existed in 2008 – will often be in the hands of various third-party service providers and therefore beyond the noteholders’ control. The key element of the decision, however, rests upon the applicability of the safe harbors in the Bankruptcy Code to the distribution of the proceeds of liquidation of collateral, all as discussed below.

Most importantly, the Bankruptcy Court considered whether the distribution of the collateral to noteholders was protected by the safe harbors’ allowance of liquidation of swap agreements. LBSF argued that it wasn’t because the term “liquidate” does not encompass within it the distribution of the proceeds of the liquidated collateral. Aided by an amicus brief prepared by Freshfields, defendants argued that applicable precedent, the plain language of the safe harbors and their legislative history all supported interpreting the term “liquidate” to include both the liquidation of the collateral and the distribution of the proceeds thereof. The Bankruptcy Court agreed with the defendants, and concluded that the plain meaning of liquidation necessarily entails deciding who gets the liquidation proceeds. In so ruling, the Bankruptcy Court noted that recent Second Circuit pronouncements with respect to the safe harbors required the safe harbors to be applied literally and broadly.

It should be noted that in the transactions covered by yesterday’s decision, the priority of payment provisions were clearly a part of the swap agreements, making it relatively easy to find that they were included within one of the Bankruptcy Code’s safe harbors. In the earlier BNY and Ballyrock decisions, the payment priority terms were not clearly incorporated into the swap agreements, giving rise to the argument that the flip clause was beyond the scope of the protected swap agreement. This factual distinction highlights the importance of proper drafting in order to obtain the full benefits of the safe harbors.

Finally, the Bankruptcy Court declined to adopt the “singular event” theory created by the Bankruptcy Court in BNY and Ballyrock. In so doing, the Bankruptcy Court noted the important “need for uniformity” and “readily applicable substantive legal principles,” rejecting the rationale that the “unique” circumstances of Lehman’s bankruptcy warranted a departure from the plain language of the anti-ipso facto provision of the Bankruptcy Code. The Bankruptcy Court thus reaffirmed the mainstream view that an entity does not get the benefit of the Bankruptcy Code’s prohibition on enforcement of ipso facto clauses until that entity files for bankruptcy. It may not obtain this benefit as of the time that an affiliate files for bankruptcy. This holding meant that terminations of swap agreements with LBSF that occurred after LBHI’s bankruptcy filing, but before LBSF’s filing, were permissible whether or not the applicable payment priority provision was an ipso facto clause or not.


Although Lehman will no doubt appeal yesterday’s decision, the holding speaks to several important conclusions, including:

  • following guidance from the Second Circuit, the Bankruptcy Court in the Southern District of New York will continue to interpret the safe harbors broadly, offering participants in the market for financial products robust protection in the event of a counterparty’s bankruptcy; and
  • however, the broad readings of the safe harbors do not ameliorate the need for market participants to clearly and expressly articulate in the protected financial contracts – such as swap, repurchase and securities lending agreements – the precise payment terms they would like to be enforced in the event of a counterparty’s bankruptcy. For instance:
    • the question of whether a payment priority provision is an ipso facto clause can be avoided by drafting payment priority provisions without providing for a default priority of payments, but rather structuring it to trigger a particular priority upon an early termination; and
    • similarly, including the priority of payment provision into a schedule to a protected financial contract, or expressly incorporating it therein by reference, will significantly increase the likelihood that it will be given the protection of the safe harbors in a subsequent litigation.