The UK Supreme Court, which is the UK's highest court, has handed down its long-awaited decision in Belmont Park Investments Pty Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc  UKSC 38, in which the Court considered the validity and enforceability of so-called "flip" clauses under English bankruptcy law.
Flip clauses are common in rated structured finance and securitisation transactions, and effectively reverse or flip a party's priority in the relevant payment waterfall below the payment of obligations owed to other creditors following certain events. The UK Supreme Court reaffirmed the earlier decisions of the English High Court and Court of Appeal that the flip clause under consideration was valid and enforceable in the circumstances and did not offend the anti-deprivation principle under English bankruptcy law.
Credit-linked notes were issued by a special purpose vehicle established by Lehman Brothers as issuer. The proceeds of issue were used to purchase collateral comprising "AAA" rated securities. The collateral was charged by the issuer in favour of BNY Corporate Trustee Services Limited as trustee to secure the issuer's obligations under the notes and under a related credit default swap entered into with Lehman Brothers Special Financing Inc. as swap counterparty. Lehman Brothers Holdings Inc., as guarantor, guaranteed the obligations of the swap counterparty under the credit default swap.
The related transaction documents contained a flip clause whereby the swap counterparty's priority over the noteholders in relation to the proceeds of enforcement in respect of the collateral would reverse or flip if there was an event of default under the swap transaction and the swap counterparty was the defaulting party.
On 15 September 2008, the guarantor filed for Chapter 11 protection under the US Bankruptcy Code and the swap counterparty did the same on 3 October 2008. Chapter 11 bankruptcy proceedings involving either the guarantor or the swap counterparty was an event of default under the swap transaction in relation to which the swap counterparty was the defaulting party.
The swap counterparty claimed that the flip clause giving noteholders priority to the proceeds of enforcement of the charge over the collateral ahead of the swap counterparty was void, as it offended the "anti-deprivation" principle under English bankruptcy law. The swap counterparty argued that by modifying its right of priority to the proceeds of enforcement following its bankruptcy, the flip clause unlawfully deprived it of property to which it was entitled in its bankruptcy.
Lower English court decisions
The English High Court, in the first instance, found that the flip clause as a matter of English law was effective and did not offend the anti-deprivation rule. Alternatively, if the clause was capable of offending the anti-deprivation rule, the rule did not apply in this case.
The flip clause took effect when the guarantor filed for Chapter 11 protection and not when the swap counterparty subsequently filed for Chapter 11 protection, therefore the effect of the clause did not deprive the swap counterparty of any property as a result of its own Chapter 11 filing. The decision of the High Court was subsequently upheld by the Court of Appeal.
UK Supreme Court decision
In considering the enforceability of the flip clause, the UK Supreme Court identified the following essential elements for the anti-deprivation rule to apply:
- there must be a deliberate intention to evade the insolvency laws – ie. a court could go behind a transaction if it was satisfied that it had been created deliberately in order to provide for a different distribution of an insolvent's property from that prescribed by law. However, a commercially sensible transaction entered into in good faith without the aim of evading the insolvency laws should not infringe the rule; and
- the deprivation must take place as a result of bankruptcy – ie. the rule will not apply if the deprivation takes place for reasons other than bankruptcy.
Focusing on the essential elements of the anti-deprivation principle, the Court held that the current transaction (including the application of the flip clause) was a commercial transaction entered into in good faith and there was no suggestion that the flip clause was deliberately intended to evade insolvency laws.
In particular, the flip clause could have applied in any number of other non-bankruptcy events that would have constituted an event of default under the swap transaction and was intended to deal with credit risk on the swap counterparty, which was a material factor in the notes obtaining a "AAA" rating.
Implications for structured finance and securitisation transactions
The Supreme Court decision lays to rest some of the uncertainty surrounding the effectiveness under English law of flip clauses used in structured finance and securitisation transactions since the original case was heard in the UK courts in 2009.
At the same time, as we discussed at the time, the decision remains in conflict with the US bankruptcy court's decision in a similar case decided in January 2010 which found that the flip clause, being an ipso facto clause, was unenforceable under US bankruptcy law. Unfortunately, while leave was granted by the US District Court to appeal the US bankruptcy court decision, the case was settled and the appeal was subsequently withdrawn.
Accordingly, the US bankruptcy court decision remains law in the US and continues to generate considerable uncertainty over the enforceability of flip clauses used in structured finance and securitisation transactions with a US nexus.