The Supreme Court has recently provided clarification on the limits of the anti-deprivation rule in insolvency law, in Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd  UKSC 38. The anti-deprivation rule permits the Court to invalidate a transaction which a party provides that, upon its bankruptcy, its property is to pass to someone other than its insolvent estate.
Using subscription monies provided by noteholders, an SPV issuer purchased certain bonds as collateral. The collateral was vested in a corporate trustee.
The issuer entered into a credit default swap with Lehman Brothers Special Financing Inc (“LBSF”) pursuant to which LBSF paid the issuer the amounts owed by the issuer to the noteholders, and the issuer paid to LBSF the interest received on the collateral held by the trustee. The swap was linked to a number of reference entities. The performance of the notes issued by the issuer was linked to the performance of the reference entities – the amount payable by LBSF to the issuer was correspondingly reduced if credit events occurred among the reference entities: LBSF was therefore gambling that enough credit events would occur for LBSF to be required to pay an amount less than the noteholders had invested. Conversely, the noteholders were gambling that the reference portfolio was safe, and accordingly that LBSF would always keep the issuer in funds. Upon the maturity of the notes, the noteholders would receive their principal in full, and LBSF would receive the value of the collateral.
The collateral secured the performance by the issuer of its obligations to the noteholders and to LBSF. The documents imposed a priority regime with respect to the collateral. This priority regime contained what is known as a “flip”. In the usual course, LBSF had priority to the collateral. However, if there were an “event of default” under the swap agreement, which included the insolvency or bankruptcy of LBSF or its parent company LBHI, the noteholders would enjoy priority to the collateral.
Decision: An Emphasis on Good Faith
Following LBSF’s insolvency, the appellants in the Supreme Court (LBSF and the trustee) argued, as they had previously (and unsuccessfully) in the Chancery Division and the Court of Appeal, that the “priority flip” upon LBSF’s/LBHI’s insolvency breached the anti-deprivation rule, because its purpose was to withdraw assets (the collateral) from LBSF’s liquidation, thereby reducing the value of LBSF’s insolvent estate to the detriment of its creditors. The Supreme Court rejected this argument.
Lord Collins delivered the leading judgment. He approved the distinction between, on the one hand, an owner of property contracting to the effect that the interest of a recipient of the property qualified in the event of the recipient’s bankruptcy (for example, a protective trust where the beneficiary’s interest expires on its bankruptcy), and on the other hand, the owner qualifying his own interest in the event of his own bankruptcy. Lord Collins said that the purpose of the anti-deprivation rule was to prevent parties defrauding their bankruptcy creditors. The rule was directed to “intentional or inevitable evasion” of the principle that the debtor’s property is part of the insolvent estate – as such, the rule is to be applied “in a commercially sensitive matter”. While Lord Collins accepted that a subjective intention to defeat the insolvency rules was not required to trigger the anti-deprivation rule, he suggested that in borderline cases a “commercially sensible transaction entered into in good faith” would not infringe the rule. Lord Collins’s conclusion was that the “flip” in issue was part of a complex commercial transaction negotiated and entered into in good faith by sophisticated parties. The Court should be slow to invalidate their bargain and the anti-deprivation rule did not apply.
The Source of the Asset
Importantly, Lord Collins was persuaded of this in no small part because the collateral was essentially the proceeds from the noteholders’ subscription payments for the notes. Accordingly, the property priority to which was in dispute was not LBSF’s. Lord Collins said that if the assets in question belonged to someone other than the bankrupt, this could be an important, and in some cases decisive, factor in a conclusion that the transaction was commercial, entered into in good faith, and therefore outside the scope of the anti-deprivation rule.
Although four members of the Court agreed with Lord Collins without comment (Lords Phillips, Hope and Clarke, and Lady Hale), Lord Walker gave a short, separate judgment in which he endorsed the “own asset” test. In support of this, he referred to Lomas v JFB Firth Rixson Inc  EWHC 3372 (Ch) (summarised above), in which Briggs J drew a distinction between assets which were rights in action representing a quid pro quo for something already done, sold, or delivered before the insolvency, and those which represented a quid pro quo for services yet to be rendered or something still to be supplied by the insolvent party. In the former case, the anti-deprivation rule would more readily apply. This seems sensible, for commercial contracts often feature provisions mandating that performance may be withheld in the case of the other party’s insolvency. A rule invalidating such provisions would have to be enacted by the legislature – as it has been in the United States under the Bankruptcy Code – rather than imposed on the commercial community by the courts.
Lord Mance, writing separately, agreed Briggs J’s test from Lomas, but disagreed with the “own asset” rule, (i.e. with Lord Walker as to the thinking behind Lomas). Lord Mance thought the flaw in Lord Collins’s analysis was that it implied that the noteholders had an inherent right to contractual priority to the collateral, or to the collateral itself. Lord Mance thought, rather, that the noteholders’ rights depended upon the terms of the documentation, as did LBSF’s. Nothing was to be gained, said Lord Mance, by enquiring into the source of the collateral – for what if rather than the “flip” clause, there were no collateral and simply a provision depriving LBSF of the right to payment if it was the defaulting party?
There is intuitive appeal in Lord Mance’s approach. The test in Lomas is not concerned with the source of the asset in question, but rather its form and operation. In complex, lawyered transactions, the parties have often created a structure whereby assets are contributed by one party to secure the obligations of another. In such a situation, an attempt to deprive the bankrupt estate of an asset to which it would be ordinarily entitled should not be allowed to proceed on the basis that the bankrupt was not the original source of the assets. The key focus should rather be on the terms of the deal and whether they amount to a bad faith attempt to deprive the insolvent estate.