On Jan. 25, 2010, the U.S. Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) held that a trust deed provision reversing a priority of payment waterfall upon the bankruptcy of a credit support provider under a swap agreement is unenforceable under the U.S. Bankruptcy Code (the “Bankruptcy Code”).

Reversals in priority of payment between noteholders and swap agreement counterparties upon the counterparty’s (or its credit support provider’s) bankruptcy are standard in structured finance transactions. The Bankruptcy Court’s decision raises some doubt as to whether these standard provisions will be enforceable in other Chapter 11 cases.

To date, no party has appealed the Bankruptcy Court’s decision. If the decision stands, it could result in significant recoveries by Lehman Brothers Special Financing Inc., as swap counterparty in numerous similar transactions, and, as a result, greater recoveries to its creditors. On the other hand, noteholders in structured financings (such as CDOs) can expect reduced recoveries. The Bankruptcy Court’s decision could also result in downgraded ratings for outstanding CDO-issued notes.

The Dante Transaction

A predecessor to BNY Corporate Trustee Services Limited established a multi-issuer secured obligation program with Dante Finance Public Limited Company in October 2002 (the “Dante Program”).

As part of the Dante Program, Perpetual Trustee Company Limited (“Perpetual”) held credit-linked synthetic portfolio notes (the “Notes”) issued by Saphir Finance Public Limited Company (“Saphir”), a special purpose vehicle created by Lehman Brothers International (Europe). Lehman Brothers Special Financing Inc. (“LBSF”) entered into swap agreements with Saphir (the “Swap Agreements”). Lehman Brothers Holdings Inc. (“LBHI”) served as credit support provider under the Swap Agreements. Both the Notes and the obligations to LBSF under the Swap Agreements were secured by the same collateral (the “Collateral”).

Under the supplemental trust deed, the Swap Agreements, and the agreements underlying the Notes (collectively, the “Transaction Documents”), LBSF’s rights to the Collateral under the Swap Agreements are senior to Perpetual’s rights to the Collateral under the Notes. If an event of default occurs on the part of LBSF under a Swap Agreement, however, the priorities are reversed, giving Perpetual rights to the Collateral senior to those of LBSF. The events of default under the Swap Agreements include the bankruptcy filing of any party, including LBHI, as credit support provider.

The Lehman Brothers Bankruptcy Cases

LBHI commenced a case under Chapter 11 of the Bankruptcy Code on Sept. 15, 2008, and LBSF commenced a Chapter 11 case on Oct. 3, 2008.

Saphir sent notices to LBSF terminating the Swap Agreements on Dec. 1, 2008. The termination notices designated LBSF’s commencement of a bankruptcy case as an event of default under the Swap Agreements and specified Dec. 1, 2008 as the “Early Termination Date” of the Swap Agreements.

The U.K. Litigation

After LBHI and LBSF commenced their bankruptcy cases, Perpetual commenced litigation in the United Kingdom seeking priority of payment over LBSF in accordance with the Transaction Documents. Following a trial, the English High Court of Justice, Chancery Division, issued a judgment in favor of Perpetual, holding, among other things, that Perpetual’s rights to the Collateral became senior to LBSF’s rights to the Collateral on Sept. 15, 2008, when LBHI commenced its bankruptcy case.

The English Court of Appeal, Civil Division, unanimously affirmed the High Court’s judgment on Nov. 6, 2009. The Court of Appeal also determined that LBSF lost no property right or interest as a result of the shift in priority to the Collateral because LBSF’s interest in the Collateral had always been contingent. The Court of Appeal denied LBSF’s motion for leave to appeal its decision to the Supreme Court of England and Wales.  

The U.S. Litigation

While the litigation was pending in the U.K., LBSF commenced an action in the Bankruptcy Court seeking a declaratory judgment that (i) the provisions in the Swap Agreements modifying LBSF’s payment priority upon an event of default constitute unenforceable ipso facto clauses, and (ii) any action to enforce the provisions modifying LBSF’s rights to the Collateral as a result of its bankruptcy filing violate the Bankruptcy Code’s automatic stay provision.

The Bankruptcy Court observed that the U.K. courts did not address U.S. bankruptcy law issues in their decisions, and the Bankruptcy Court declined to give preclusive effect to the U.K. judgments.

In granting LBSF’s motion for summary judgment, the Bankruptcy Court held that the provisions modifying priority of payment upon a swap counterparty’s bankruptcy were unenforceable ipso facto clauses and that enforcing those provisions violated the automatic stay.

The Bankruptcy Court’s Reasoning

Ipso Facto Provisions and the Automatic Stay. Under section 541(c)(1)(B) of the Bankruptcy Code, an interest of the debtor in property becomes property of the bankruptcy estate notwithstanding a provision in an agreement “that is conditioned on . . . the commencement of a case under [the Bankruptcy Code]” (emphasis added). Similarly, under section 365(e)(1) of the Bankruptcy Code, an executory contract (i.e., a contract on which performance remains due to some extent on both sides) cannot be terminated or modified after the commencement of a bankruptcy case solely because of a provision in the executory contract that is conditioned on “the commencement of a case under [the Bankruptcy Code]” (emphasis added). Thus, these so-called “ipso facto” provisions are generally held to be unenforceable in bankruptcy cases.

Finding the Swap Agreements to constitute executory contracts, the Bankruptcy Court held that the Transaction Documents require a sale, realization, or enforcement of the Collateral for Perpetual to obtain rights to the Collateral senior to LBSF’s rights and that the “Early Termination Date” occurred after LBSF commenced its bankruptcy case. Indeed, Saphir sent its termination notice on Dec. 1, 2008—almost three months after the LBSF bankruptcy filing. The Bankruptcy Court thus held that LBSF had a valuable property interest in the Transaction Documents at the time it commenced its Chapter 11 case and that LBSF’s property interest is entitled to protection under the Bankruptcy Code as property of LBSF’s estate. As a result, the Bankruptcy Court held that any attempt to enforce a reversal of rights to the Collateral would violate the Bankruptcy Code’s automatic stay, which prohibits, among other things, “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.”

The Bankruptcy Court further held that even if the commencement of LBHI’s bankruptcy case on September 15, 2008 were the operative date for subordinating LBSF’s rights to the Collateral, i.e., purporting to deprive LBSF of a property interest in the Transaction Documents before commencing its Chapter 11 case, the ipso facto prohibitions under sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code would bar the efficacy of a change in distribution rights. Noting that those Bankruptcy Code provisions reference the commencement of a case, the Bankruptcy Court held that the language is not limited to the commencement of a case by or against the debtor that is the swap counterparty. Thus, even though LBSF was the counterparty to the Swap Agreements, the commencement of a case by LBHI, as credit support provider, was sufficient to trigger the Bankruptcy Code’s ipso facto protections.

The scope of this holding remains unclear. The Bankruptcy Court stated that the relationship between the debtor that is a counterparty to the swap agreement and the debtor whose case triggers ipso facto protection under the Bankruptcy Code “is best left to a case-by-case determination.” Given the size of the Lehman Brothers corporate family and the unplanned nature of the Lehman Brothers Chapter 11 cases, the Bankruptcy Court determined that the first filing by LBHI is significant “in the context of ipso facto provisions that speak in terms of the commencement of ‘a’ case under [the Bankruptcy Code].” The Bankruptcy Court thus held that “the chapter 11 cases of LBHI and its affiliates is a singular event for purposes of interpreting this ipso facto language.”2

Safe Harbor Provisions. The Bankruptcy Code contains a “safe harbor” provision, permitting a swap counterparty to, among other things, liquidate, terminate, or accelerate one or more swap agreements upon the commencement of a bankruptcy case by the other counterparty.3 The Bankruptcy Court observed that nothing in the Swap Agreements refers to the provisions governing the relative rights of LBSF and Perpetual to the Collateral. The priority of payment provisions thus did not fall within the Bankruptcy Code’s definition of Swap Agreement and accordingly fell outside the Bankruptcy Code’s safe harbor provision.4 The Bankruptcy Court also held that because the Bankruptcy Code’s safe harbor provision deals with liquidation, termination, and acceleration of swap agreements, and not the alteration of rights as they exist, the priority of payment provision is outside the scope of the safe harbor. Subordination Agreements. The Bankruptcy Court also held that while the priority of payment provisions in the Transaction Documents may be construed as subordination agreements enforceable under the Bankruptcy Code,5 the priority scheme is not fixed. The shifting nature of the relative priorities to the Collateral remains unenforceable for the reasons discussed above.

Practical Implications

Under rating agency guidelines, it will be difficult for structured notes to have a rating higher than that of the swap counterparty (or its credit support provider) if the Bankruptcy Court’s view prevails. One possible distinction that might result in a different conclusion under the “safe harbor” in other transactions would be if the reversal of priority of payments was included in the swap agreement itself. Another possibility would be for the “normal” priority of payments to subordinate termination payments to the swap counterparty, with the priority to be reversed (and the swap counterparty to be senior) if termination occurred as a result of a default by the issuer of the structured notes or a termination event for which such issuer is the affected party. Another possibility (which was not discussed by the Bankruptcy Court) would be for the swap agreement to provide for “Automatic Early Termination” of the swap transactions to occur immediately prior to the bankruptcy filing of any party (or credit support provider). If this decision is not reversed on appeal or distinguished from other swap transactions, the way that swap transactions are executed in structured financings will need to change.

A copy of the Bankruptcy Court’s opinion can be accessed here.