The Bottom Line

In Lehman Brothers Special Financing Inc. v. Branch Banking & Trust Co. (In re Lehman Brothers Holdings Inc.), No. 18-1079, --F.3d--, 2020 WL 4590247 (2d Cir. Aug. 11, 2020), the Second Circuit held that provisions in a swap agreement calling for the alteration of payment priority upon a debtor’s bankruptcy are enforceable under the safe harbor of Section 560 of the Bankruptcy Code notwithstanding that they might otherwise be considered invalid ipso facto provisions. The decision effectively overrules a decision by the Bankruptcy Court for the Southern District of New York, issued a decade ago and also emanating from the Lehman bankruptcy, which had held that similar provisions were outside the scope of the Section 560 safe harbor.

What Happened?


Prior to the Lehman Brothers bankruptcy, Lehman Brothers Special Financing Inc. (LBSF) and certain affiliates entered into 44 synthetic collateralized debt obligations (CDOs) with 250 noteholder parties. In each of the CDO transactions, LBSF marketed and sold notes to the 250 parties through a newly created issuer, which used the proceeds from the sale of the notes governed by an indenture to purchase highly rated (collateral) securities. The issuer of the notes then sold credit default swap (CDS) protection to LBSF on a basket of reference entities under a swap agreement. Under the swap agreement (CDS), the issuer would make payment to LBSF upon the occurrence of certain “credit events” affecting the underlying entities in the basket. In that event, the issuer would use the securities purchased with the proceeds of the note issuance to fund the payment to LBSF under the CDS contract. In exchange for the protection it purchased, LBSF would make quarterly premium payments to the issuer. If none of the reference entities experienced a “credit event” before the notes matured, the noteholders would be entitled to be repaid the amount of their investment in the notes from the collateral securities. The two components of the synthetic CDO transaction — the CDO and the swap (CDS) — were documented separately, but the swap and indenture referenced each other.

The indenture also contained certain provisions in which defined events of default under the swap could lead to the trustee issuing a termination notice under the indenture. This notice would accelerate payment on the notes and also terminate the swap. Upon termination, the trustee could liquidate the collateral securities and distribute the proceeds primarily to noteholders and LBSF. The agreement provided that LBSF would enjoy payment priority over the noteholders in certain circumstances. However, under other circumstances (including in the case of a default by LBSF), the noteholders instead would receive priority over LBSF.

The bankruptcy filing of LBSF’s parent, Lehman Brothers Holding Inc., constituted an event of default under the swap agreement, triggering an early termination of the CDS. This, in turn, led to the liquidation of the collateral securities and the distribution of the liquidation proceeds under the indenture. Because LBSF was in default, the noteholders asserted payment priority and were paid roughly $1 billion out of these proceeds. The proceeds of the collateral proved insufficient to make any payment to LBSF after the payment to the noteholders, even though LBSF was owed a sizeable amount on account of the termination of the CDS (which were in-the-money to LBSF at the time of termination).

The Bankruptcy and District Court Decisions1

LBSF later commenced an adversary proceeding in the bankruptcy court alleging that the priority provisions were unenforceable as ipso facto clauses. The bankruptcy court and district court both ruled in favor of the noteholders, holding, among other things, that even if the clauses at issue were ipso facto clauses, Section 560 of the Bankruptcy Code permitted the distributions to be made. That section provides, “The exercise of any contractual right of any swap participant of financial participant to cause the liquidation, termination, or acceleration of one or more swap agreements because of a condition of the kind specified in section 365(e)(1) of this title . . . shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court . . . in any proceeding under this title.” The courts held that enforcement of the priority provisions fell squarely into the purview of this safe harbor and that normal anti-ipso facto rules should therefore not apply.2

LBSF appealed the district court’s decision to the Second Circuit.

The Second Circuit’s Decision3

The Second Circuit affirmed the district court’s decision to dismiss the case and held that Section 560 of the Bankruptcy Code (which exempts “swap agreements” from the Bankruptcy Code’s prohibition of ipso facto clauses) made the priority provisions enforceable. In so holding, the Second Circuit rejected the debtor’s arguments that (i) the priority provisions at issue were not actually part of the swap agreement but rather were contained in the related indenture, (ii) the safe harbor was intended to protect only calculation (“liquidation”) of the claim and not a distribution on the claim, and (iii) the indenture trustees were not protected parties as they were not the actual swap participants.

In particular, as to the first argument, the court held that not just the “swap agreement” itself but also related agreements (such as the indenture agreements, which contained the priority provisions and were cross-referenced in the swap agreement) are protected under Section 560. The court also rejected LBSF’s proposed narrow definition of “liquidation,” which would have effectively limited the statute to apply only to claim calculations, and embraced a broader interpretation of that term that includes the distribution of collateral. The Second Circuit also found that Section 560 still protected the priority clauses even though the trustee was the individual who liquidated and distributed the collateral. The court reasoned that, although the trustee was not the “swap participant,” the trustee’s actions stemmed from the rights of the swap participants and thus met the third prong of the test.4

Why This Case Is Interesting

In reaching its decision, the Second Circuit better enumerated the requirements of the Section 560 safe harbor, adopting a relatively broad interpretation of the three prongs required for application of the provision. The Second Circuit’s decision also effectively overrules the earlier decision by Bankruptcy Judge Peck in Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd. (In re Lehman Brothers Holdings Inc.), 422 B.R. 407 (Bankr. S.D.N.Y. 2010), which, in interpreting a different flip clause, had held (among other things) that Section 560 did not apply. To be sure, flip clauses may contain different terms and not all will be safe-harbored, but the Second Circuit was clear that in this instance at least, its recent decision “conflicts with that adopted by Bankruptcy Judge Peck.”5

The Second Circuit decision also provides much-needed clarity and certainty to structured products and structured finance practitioners that the contractual arrangements of CDO and other securitization market participants will be respected even in the context of bankruptcy. Lehman Brothers — which incidentally made significant advisory and other fees on these transactions — had actively marketed these notes on the basis of their payment subordination in the case of an LBSF default, including as a result of Lehman Brothers’ bankruptcy. Any different outcome may have frustrated the expectations of those investors. In addition, in other jurisdictions such as England, courts were quick to favor freedom of contract over the protection of an insolvent estate in similar disputes, thereby providing a platform for the issuance of those products and putting issuance subject to U.S. laws at a competitive disadvantage. The Second Circuit decision reestablishes parity in that respect.