Structured finance transaction documents have typically included subordination provisions in their post-default waterfalls, effectively changing a swap counterparty’s right to get paid from above that of the noteholders to below that of the noteholders. In January 2010, in a case relating to the “Dante” credit-linked note program, a New York bankruptcy court voided certain document provisions providing for the subordination of Lehman Brothers Special Financing Inc.’s rights as swap counterparty to an early termination payment when the swap counterparty or one of its close affiliates went into bankruptcy. In effect, the bankruptcy court held that such clauses altering the priority of payment constitute unenforceable ipso facto clauses under the U.S. Bankruptcy Code (the “Bankruptcy Code”). After an appeal was filed, the parties settled the matter later that year, leaving market participants with substantial uncertainty in connection with similar clauses.1

The same issues have arisen in the United Kingdom, but with a different outcome. In Belmont Park Investments Pty Limited & ors v. BNY Corporate Trustee Services Limited and Lehman Special Financing Inc., the U.K. Supreme Court decided on July 27th that a “flip” clause in the relevant documentation did not violate the common-law principle of “anti-deprivation,” which (similar to the Bankruptcy Code’s ipso facto rule) invalidates contractual provisions having the effect of transferring the property of a debtor upon its insolvency, hence depriving the bankruptcy estate of that asset. In its decision, the court first reviewed the anti-deprivation principle’s development to describe its nature and limits. In doing so, the court noted that the absence of good faith, or an intention to obtain an advantage over creditors in the bankruptcy, was an essential element in the application of the principle. Indeed, the court pointed out that, historically, where the principle has been held not to apply, good faith and commercial sense of the transaction have been important factors. Applying this understanding to the transaction at issue, the court concluded that there was no evidence that the “flip” clauses were deliberately intended to evade insolvency law (as evidenced by the numerous other non-bankruptcy defaults that also would trigger a change in priority). The court further noted that Lehman itself had designed, arranged and marketed the Dante program, and that the flip clauses (more specifically, noteholder priority to collateral upon a Lehman bankruptcy) was a very material factor in the notes obtaining a triple-A rating, hence enabling Lehman to sell them to non-banks. In addition, the collateral was purchased with funds supplied by the noteholders, not Lehman. In bolstering its conclusion, the court also emphasized that “party autonomy” (i.e., the ability of sophisticated counterparties to agree to commercial terms at arms’ length) was at the heart of English commercial law, particularly where complex financial instruments are involved.  

The inconsistency of the New York and U.K. decisions leaves market participants with a stark difference of opinion across jurisdictions and may raise the possibility of forum-shopping in connection with future structured finance transactions.