The Supreme Court recently considered the scope of the anti-deprivation principle, in Belmont Park Investments PTY Limited (respondent) v. BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc (appellant) [2011] UKSC 38 (Belmont). Understanding the scope of this principle is important for anyone entering a contract where the parties’ rights and obligations change if one of them enters an insolvency procedure. Robert Spedding explains how the courts applied the principle in Belmont and makes some practical suggestions for avoiding problems.

What is the Anti-Deprivation Principle?

The term “anti-deprivation principle” is relatively recent, but the principle itself is well established at common law. The principle is essentially that a contractual term will be void which provides that one party must hand over one or more of its assets to another party if, and only if, the first party enters an insolvency procedure. For example, the English courts have found that the principle made invalid a clause in an agreement providing that party A’s obligation to compensate party B for a particular loss would automatically terminate if party B entered insolvency proceedings. The rule’s purpose is to ensure that a person’s assets are available to its creditors generally on its insolvency.

Belmont – the facts

Lehman Brothers set up a special purpose vehicle (the Issuer) which borrowed money by issuing notes. It also entered into a credit default swap with a Lehman Brothers entity (LBSF) in respect of its obligations under the notes. The Issuer granted security over certain “collateral” for its obligations to both noteholders and LBSF. Under the terms of the transaction documents (which were governed by English law), priority in relation to the proceeds of the collateral switched from LBSF to the noteholders on the occurrence of an event of default. One event of default was the insolvency of LBSF, which occurred when it went into Chapter 11 protection in the US. LBSF’s case was that this “flip” clause breached the anti-deprivation principle because it unlawfully denied its creditors access to the proceeds of the collateral solely because LBSF went into Chapter 11.

Belmont – the Court’s verdict

The High Court, the Court of Appeal and the Supreme Court all agreed that the contractual change in priority was effective under English law. The Supreme Court gave various reasons for its decision, including:

  • The principle did not apply because the Chapter 11 filing by LBSF’s parent entity, LBHI, was also an event of default. This other event of default triggered the change in priority and predated LBSF’s insolvency. If the deprivation occurs for reasons other than the claimant’s own insolvency, the anti-deprivation principle does not apply.
  • The event of default under the swap agreement did not deprive LBSF of any “property” and so the anti-deprivation principle could not apply.
  • Even if LBSF’s original priority position was its “property”, this would have been a limited property interest lasting only until the occurrence of a certain event, not a permanent interest which was given up on a certain event. This follows the same principle under which a landlord can have a right to end a lease on the tenant’s insolvency without offending the anti-deprivation principle.

But perhaps the key point made by the Supreme Court was a more general one: the parties made the contract in good faith and without intending to evade insolvency laws. The Court noted that any event of default would have triggered the "flip" term; it was not a term that would only become relevant on LBSF's entry into an insolvency procedure. On that basis, the principle did not invalidate the term changing the creditors’ respective priorities. The Supreme Court therefore gave a narrow interpretation of the anti-deprivation principle, concluding that “it is desirable that, so far as possible, the courts give effect to contractual terms which parties have agreed”.

Avoiding the Problem

Following Belmont, parties entering an English law contract can be more confident that the anti-deprivation principle will not invalidate the terms they are agreeing. However, they should still bear the following points in mind:

  • Parties to a contract cannot avoid the mandatory requirements of insolvency legislation. If a transaction is clearly intended to avoid those mandatory requirements, the anti-deprivation principle could apply. (The transaction is also likely to face other challenges.)
  • This should be a given, but ensure the transaction is commercially sensible and is entered into in good faith. So long as this applies, the courts should be reluctant to find that it infringes the anti-deprivation principle.
  • An “insolvency proceedings” event of default will not offend the principle, provided there are other events of default which would have the same effect.
  • Avoid “back-end” fees or other extra costs that are payable by a party only if it enters an insolvency procedure.
  • A right which arises before the relevant party’s insolvency or for a reason other than the relevant party’s insolvency will not breach the anti-deprivation principle.
  • The anti-deprivation principle should not apply if the contract in question is a lease or some other interest which determines on insolvency (a so-called “flawed asset”) rather than an absolute interest which can be terminated on insolvency. However, the courts have acknowledged that it is often difficult to distinguish between these two types of assets.  

Law stated as at 17 November 2011