In Lehman Brothers Special Financing, Inc. v. Ballyrock ABS CDO 2007-1 Limited (In re Lehman Brothers Holdings, Inc.), Adv. P. No. 09-01032 (JMP) (Bankr. S.D.N.Y. May 12, 2011) [hereinafter “Ballyrock”], the United States Bankruptcy Court for the Southern District of New York held that a contractual provision that subordinates the priority of a termination payment owing under a credit default swap (CDS) to a debtor in bankruptcy, and which caps the amount of the termination payment, may be an unenforceable ipso facto clause under section 541(c)(1)(B).

In 2007, Lehman Brothers Special Financing, Inc. (LBSF) and Ballyrock ABS CDO 2007-1 Limited (“Ballyrock ABS”) entered into a CDS contract, which was evidenced by an ISDA Master Agreement. Ballyrock ABS then entered into an indenture with an institutional trustee and issued notes to investors. The indenture required that all disbursements comply with a specific priority of payment—that is, a waterfall.

Pursuant to the waterfall, a termination payment from the in-the-money counterparty to an out-ofthe- money counterparty was accorded a high priority and it made no difference whether the in-themoney counterparty—here, LBSF—was also the defaulting party. Despite the priority scheme, the indenture provided that if LBSF’s default was because of bankruptcy (a “Bankruptcy Default”), its right to a termination payment would be capped and deeply subordinated in the waterfall (the “Bankruptcy Default Waterfall”).

Lehman Brothers Holdings, Inc.’s (LBHI) bankruptcy filing caused a Bankruptcy Default under the indenture. Before Ballyrock ABS distributed proceeds pursuant to the Bankruptcy Default Waterfall, LBSF commenced an adversary proceeding seeking to, among other things, enjoin the use of the Bankruptcy Default Waterfall. Ballyrock ABS filed a motion to dismiss the complaint, arguing that LBSF had failed to state a claim.

The court denied the motion to dismiss as to the counts seeking to invalidate the Bankruptcy Default and the application of the Bankruptcy Default Waterfall.1 In support of its ruling, the court first noted the similarity between Ballyrock and its holding in Lehman Bros. Special Fin. Inc. v. BNY Corporate Tr. Servs. (In re Lehman Bros. Holdings, Inc.), 422 B.R. 407 (Bankr. S.D.N.Y. 2010) [hereinafter “Dante”], in which it invalidated the operation of a so-called “flip” clause. The court stated, “[The] analysis from the [Dante] decision would render ineffective the changes in the Waterfall that would result from the activation of the [Bankruptcy Default] Clause.”

The court then held that the Bankruptcy Default clause was not protected by any provision contained in the Bankruptcy Code’s safe harbor provision, reasoning that Section 560 of the Bankruptcy Code only protects a non-defaulting swap participant’s contractual rights to liquidate, terminate or accelerate “one or more swap agreements because of a condition of the kind specified in Section 365(e)(1)” of the Bankruptcy Code. According to the court, the plain meaning of the words “liquidation, termination, or acceleration” were not applicable to a provision that seeks to reorder distributions based on a bankruptcy filing.

Ballyrock is yet another decision from the Bankruptcy Court for the Southern District of New York interpreting the safe harbor provisions narrowly and in a debtor’s favor. Although the procedural context of this ruling—a motion to dismiss—should be noted, it appears that the bankruptcy court in Ballyrock may adopt its reasoning in Dante. Notably, the Dante litigation settled shortly after the United States District Court for the Southern District of New York granted interlocutory review of the bankruptcy court’s decision, stating that the Dante decision has “potentially far-reaching ramifications for international securities markets and has triggered uncertainty in the financial community” and that the bankruptcy court engaged in a “novel statutory interpretation to the circumstances at hand.”2 There appear to be no other bankruptcy cases taking the circumscribed approach illustrated in Dante or Ballyrock.