Lehman Brothers Special Financing, Inc. v. Ballyrock ABS-CDO 2007-1 Limited (In re Lehman Brothers Holdings, Inc.) No. 09-01032 (JMP) (Bankr. S.D.N.Y. May 12, 2011)  


Lehman Brothers Special Financing and Ballyrock entered into an ISDA Master Agreement to engage in credit swaps, in connection with which Lehman’s parent provided a guarantee. Ballyrock then entered into an indenture with a U.S. bank and issued several classes of notes to investors. The bankruptcy filing of any party or guarantor constituted an event of default under the Master Agreement, and default under the Master Agreement altered the defaulting party’s priority status and capped its distribution. Following the bankruptcy of the Lehman entities, Ballyrock declared a default and liquidated the assets, and the indenture trustee announced a future distribution to senior noteholders of $137 million. The indenture trustee intended to distribute only $30,000 to LBSF because LBSF’s bankruptcy subordinated its priority status to that of the senior noteholders and prohibited it from receiving the $137 million. LBSF filed an adversary proceeding to enjoin the $137 million distribution, arguing that the subordination of its priority status constituted an invalid forfeiture penalty and ipso facto clause under the Bankruptcy Code. The court denied Ballyrock’s motion to dismiss, holding that the Master Agreement did include an ipso facto clause that may not be enforced to deprive the debtor of rights based on the bankruptcy filings.  


In July 2007, LBSF and Ballyrock executed an ISDA Master Agreement. Lehman Brothers Holdings, Inc. issued a guarantee in connection with the Master Agreement. Ballyrock, in turn, executed an indenture, under which it issued several classes of notes to investors. The indenture established a waterfall system of distribution, pursuant to which senior noteholders must be paid in full before distributions could be made to junior noteholders. The Master Agreement and indenture established the terms that governed the contractual relationship between Ballyrock and LBSF. Under these contracts, Ballyrock sold, and LBSF purchased, loss protection with respect to collateralized debt obligations and mortgage-backed securities.

Pursuant to the Master Agreement, the bankruptcy filing of either party or guarantor constituted an event of default. Upon default, the non-defaulting party could designate an Early Termination Date with respect to all outstanding transactions under the credit swap. On this Early Termination Date, the outof- the-money party would be required to make a termination payment to the in-the-money party, based on a standard industry calculation known as the “Second Method.” Under the Second Method, it did not matter if the defaulting party was the in-the-money party—payment was still due in full. As of the Early Termination Date, Ballyrock was out-of-the-money, and LBSF, the debtor, was inthe- money. Thus, Ballyrock liquidated the assets, and the indenture trustee made an initial distribution to senior noteholders of $189 million. But for the bankruptcy, LBSF would have been paid the balance of $137 million; however, the terms of the indenture reduced LBSF from third priority down to nineteenth, and capped the debtor’s distribution at $30,000. The indenture trustee announced that it would distribute the $137 million to other senior noteholders.  

LBSF instituted an adversary proceeding seeking (1) a declaratory judgment that the proposed distribution was improper, and (2)) to enjoin the distribution, asserting that the change in its status under the indenture as a result of bankruptcy filing was an invalid ipso facto clause. Ballyrock responded with a motion to dismiss. The Bankruptcy Court denied Ballyrock’s motion and held that the subject provision was an ipso facto clause.  


The issue before the court was “whether a provision in the documentation that adversely impacts a debtor’s right to property upon the filing of a chapter 11 petition may constitute an unenforceable ipso facto clause.”

Section 365(e)(1) of the Bankruptcy Code provides that “an executory contract…may not be terminated or modified, and any right or obligation under such contract…may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract… that is conditioned on…the commencement of a case under this title….” Section 541(c)(1)(B) also invalidates ipso facto clauses, providing that a debtor’s interest in property “becomes property of the estate…notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law…that is conditioned on…the commencement of a case under this title…and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.”

The court noted that these statutory provisions are broadly worded, and protect a debtor not only in the instance of its own bankruptcy filing, but in that of a related entity as well. This is because the statutory sections are triggered by the “commencement of a case under this title,” rather than being triggered under the more narrow circumstance of a case “by or against the debtor.” In the earlier case of Lehman Bros. Special Fin. Inc. v. BNY Corporate Tr. Servs. (In re Lehman Bros. Holdings, Inc.) 422 B.R. 407 (Bankr. S.D.N.Y. 2011), the same bankruptcy judge had analyzed a similar situation. In the earlier case, the court had held that a “flip” provision in the subject agreements was an ipso facto clause in violation of the Bankruptcy Code. In the instant case, the court relied on its earlier reasoning to hold that the contractual provisions of the Master Agreement and indenture also violated the Code.

Ballyrock argued that the waterfall provisions were protected by the safe harbor of section 560. This section protects a non-defaulting swap participant’s right to “(i) liquidate, terminate or accelerate ‘one or more swap agreements because of a condition of the kind specified in section 365(e)(1)’ of the Bankruptcy Code or (ii) ‘offset or net out any termination values or payment amounts arising under or in connection with the termination, liquidation, or acceleration of one or more swap agreements…’” Relying on prior caselaw, the court stated that other courts had narrowly construed the language, refusing to look beyond the plain meaning of the words, “liquidate, terminate or accelerate.” Because the right to liquidate, terminate or accelerate was not at issue here, Ballyrock was not entitled to protection under the safe harbor.

The court denied Ballyrock’s motion to dismiss and held that the default provisions of the contracts functioned as unenforceable ipso facto clauses because they effectively eliminated the right to receive a termination payment due to commencement of the LBSF bankruptcy, and that Ballyrock was not entitled to safe harbor protection.  


This decision reinforces the impermissibility of ipso facto clauses and provides a debtor-favorable ruling that narrows the safe harbor provision contained in section 560 of the Bankruptcy Code.