On December 15, 2010, Judge James Peck of the US Bankruptcy Court for the Southern District of New York (the Bankruptcy Court) approved Lehman Brothers Special Financing Inc.’s (LBSF) motion (the Motion) for approval of a settlement among LBSF, BNY Corporate Trustee Services Limited (BNY), Perpetual Trustee Company Limited (Perpetual) and others relating to certain note issuance and swap transactions with Saphir Finance Public Limited Company (Saphir) under a program known as the Dante Program. The settlement (the Settlement) resolves closely-watched, pending appeals in both the United States and England under the titles Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Limited (in the United States) and Perpetual Trustee Company Limited v. BNY Corporate Trustee Services Limited (in England) each concerning the validity of "flip clauses" in swap transactions.


Pursuant to the Dante Program, a multi-issuer secured obligation issuance program, Saphir, an affiliate of Lehman Brothers Holding Inc. (LBHI), issued notes to the public and entered into a swap agreement with LBSF guaranteed by LBHI. BNY, as collateral trustee, held various assets for the benefit of Saphir’s creditors: Perpetual, acting as trustee for the note holders, and LBSF, as swap counterparty. Under the original terms of the Dante Program, LBSF enjoyed priority in payment to Perpetual. However, priority was subject to a flip clause providing that an event of default with respect to LBSF under the swap agreement, including a Chapter 11 filing by LBSF or LBHI, reverses the priority of payment such that Perpetual (on behalf of the note holders) would receive payment ahead of LBSF.

The US and English Litigation

LBHI filed a petition for Chapter 11 protection on September 15, 2008, and LBSF filed its own Chapter 11 petition on October 3, 2008. On December 1, 2008, Saphir sent notices to LBSF calling an event of default based on LBSF’s bankruptcy filing, exercising certain remedies, including the flip clause, and purporting to terminate the swap agreement. If effective, such termination would obligate Saphir to redeem the notes, with payment going first to Perpetual, on behalf of the holders of notes issued through the Dante Program.

Perpetual filed suit against BNY (the English Litigation) in the English High Court of Justice, Chancery Division (the High Court) seeking recognition of its payment priority under the terms of the swap agreement (Noteholder Priority), and LBSF intervened. The High Court granted enforcement of the flip clause and found September 15, 2008 — the date of the LBHI’s Chapter 11 filing — to be the effective date for the flip to Noteholder Priority. LBSF appealed the High Court’s decision, and the English Court of Appeal unanimously affirmed the judgment. LBSF filed a further appeal on March 26, 2010, and the Supreme Court of the United Kingdom agreed to hear the case and scheduled hearings for March 2011.

After the English Litigation had been initiated, on May 20, 2009, LBSF filed a complaint against BNY (the US Litigation), via an adversary proceeding in the jointly-administered LBHI Chapter 11 cases before the Bankruptcy Court, seeking to bar enforcement of the flip clause. On June 10, 2009, LBSF filed a motion for summary judgment. On January 25, 2010, the Bankruptcy Court granted LBSF’s motion for summary judgment in a memorandum decision holding that the ipso facto prohibitions of sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code barred enforcement of the flip clause, because the flip clause was triggered by LBSF’s bankruptcy filing and was not contained in any agreement protected by the safe harbors of the Bankruptcy Code. Furthermore, the Bankruptcy Court held that the shift in payment priority would constitute an invalid ipso facto clause even if it was automatically triggered upon LBHI’s earlier bankruptcy filing — because LBHI and its affiliates operated as an "integrated enterprise," LBSF was entitled to claim the ipso facto prohibitions as of LBHI’s earlier Chapter 11 filing. On July 19, 2010, the Bankruptcy Court entered an order memorializing its Memorandum Decision in favor of LBSF (the Summary Judgment Order).

On September 20, 2010, the United States District Court for the Southern District of New York (the District Court) granted BNY’s motion for leave to appeal the summary judgment order (the US Appeal). Judge Colleen McMahon found that interlocutory review was warranted because (1) the issue presented to the Court was a difficult question of first impression, (2) Judge Peck’s decision resolved controlling questions of law that may dispose of the ultimate issue in the adversary proceeding and (3) Judge Peck’s decision has "potentially far-reaching ramifications for international securities markets and has triggered uncertainty in the financial community."

The Settlement

While the appeals of Judge Peck’s decision and the English Litigation were pending, LBSF, Perpetual and Saphir conducted settlement negotiations. Upon reaching the Settlement, LBSF (together with the Official Committee of Unsecured Creditors appointed in the Lehman Chapter 11 cases (the Creditors’ Committee) obtained a stay of the US Appeal so that Lehman could seek Bankruptcy Court approval of the Settlement. The Settlement is comprised of two agreements (1) the Termination and Settlement Agreement between LBSF, Saphir, BNY, The Bank of New York Mellon, London Branch, The Bank of New York Mellon (Ireland) Limited, Perpetual, LBHI and LBHI Estates Ltd (the Termination and Settlement Agreement) in respect of the swap transactions between LBSF and Saphir and the related Series 2004-11 AUD 75,000,000 Synthetic Portfolio Notes due 2011 and Series 2006-05 AUD 50,000,000 Synthetic Portfolio Notes due 2011 each issued by Saphir, and (2) the Settlement Payment Deed between Perpetual and LBSF (the Payment Deed). LBSF submitted the Payment Deed as an attachment to its Motion in a redacted form that does not disclose the settlement amounts and the split of collateral between LBSF and Perpetual.

Termination and Settlement Agreement

The key terms of the Termination and Settlement Agreement, which was amended pursuant to a Deed of Amendment Relating to the Termination and Settlement Agreement, dated December 8, 2010, include:

  • Redemption of the notes
  • Termination of the swap transactions
  • Mutual release of claims relating to the notes and the swap transactions
  • LBHI, as credit support provider, is relieved of any liability
  • The collateral securing the notes and the swap transactions will be sold
  • Proceeds from the sale of the collateral will, following payment of prior costs and expenses, be used by Saphir to pay moneys payable to LBSF and Perpetual to a settlement payment agent, which will distribute the funds in accordance with the Payment Deed
  • Following the effective date of the Settlement, but prior to receipt of the settlement payment by LBSF, the US Litigation and English Litigation will be dismissed

The Termination and Settlement Agreement is further subject to the following conditions:

  • A stay of the US Appeal (which was granted by the District Court)
  • Perpetual obtaining advice from the Supreme Court of New South Wales, Australia, that its entry into and performance of its obligations under the Settlement are a proper exercise of its powers and duties, as trustee for the note holders
  • The Lehman Debtors obtaining approval of the Settlement from the Bankruptcy Court (which was granted by the Bankruptcy Court)

Payment Deed

The key terms of the Payment Deed include:

  • Within one day after receipt of the payment from Saphir pursuant to the Termination and Settlement Agreement, the settlement payment agent will make a payment to LBSF, and hold the remainder of the money until a later date agreed to by the parties.
  • The settlement payment agent will pay a final sum to Perpetual into a separate controlled moneys trust account, which amount (plus interest) is to be disbursed to Perpetual for the benefit of the note holders upon written request.
  • Both Perpetual and LBSF agree to indemnify the settlement payment agent against any liabilities arising from (1) performance of its obligations under the Payment Deed, (2) the settlement payment agent entering into or participating in the Payment Deed or (3) any court proceedings, dispute or arbitration relating to the Payment Deed, other than liability due to breach of the Payment Deed, fraud, negligence or misconduct.
  • Each party will bear its own costs and expenses relating to the Payment Deed, except that LBSF will pay Perpetual’s costs relating to part of the English Litigation.

Objections and Resolution

The Lehman Debtors’ Motion for approval of the settlement met with several objections, including objections by the Liquidators of Lehman Brothers Australia Limited appointed by the Federal Court of Australia (the Liquidators) and certain note holders. The Liquidators objected to the Settlement to the extent it binds them or precludes them from bringing an action against the Debtors in connection with the notes issued under the Dante Program. The Liquidators further argued that they were not aware of the "most important" terms of the Settlement — the amount due to LBSF before payment to Perpetual. In addition, note holders referring to themselves as the Belmont Noteholders filed an objection to reserve their rights in future litigation. The Belmont Noteholders requested that the Bankruptcy Court include in any order approving the settlement agreement language stating that there is no such preclusive effect of such order on the Belmont Noteholders.

All objections were resolved by the hearing date of December 15, 2010, and the Motion went before Judge Peck on an uncontested basis. Judge Peck entered an order granting the Motion on December 16, 2010, and the appeal of the Bankruptcy Court’s decision was dismissed by the District Court on January 10, 2011 pursuant to a stipulation submitted by the parties.


The Settlement, if effective, will resolve both the US Litigation and the English Litigation before any appellate court can review the Bankruptcy’s Court’s decision. Accordingly, the Settlement does not affirm or overturn Judge Peck’s controversial decision in the US Litigation barring enforcement of a flip clause based on the prohibitions on ipso facto clauses under section 365(e) of the Bankruptcy Code. American courts will not be bound to follow the Bankruptcy Court’s decision but may look to the decision as persuasive; on the other hand they will be equally free to reject it entirely. The uncertainty in derivatives markets that has resulted from the Bankruptcy Court’s decision will not be resolved until a future case. The Lehman Debtors have filed at least six separate complaints asserting claims that flip clauses violate the prohibition on ipso facto under the Bankruptcy Code based on Judge Peck’s reasoning in his decision.1 If such cases are not settled, they may result in appellate rulings that could work to resolve the present uncertainty in derivative markets, and they will be closely watched as a result.

Until future litigation results in controlling precedent, structured transaction and derivative lawyers should carefully consider the drafting of current and future flip clauses and swap agreements to avoid the pitfalls highlighted by the Bankruptcy Court’s decision in the US Litigation. Please see Latham’s prior Client Alert2 dated May 13, 2010 or contact any of the authors for a further discussion of the issues raised by the Bankruptcy Court’s decision.