Structured finance transactions frequently subordinate a swap counterparty’s rights to termination payments upon termination of a swap by reason of counterparty default. Such a provision has recently been upheld by an English court. As the case concerns the insolvency of Lehman Brothers however, the US courts must also make a decision on the same provision.  

In July, the High Court in London upheld a provision common in the payment waterfalls relating to asset backed securities to the effect that a swap counterparty has priority over noteholders in the payment of proceeds by the issuer other than where the swap counterparty is itself in default, whereupon it is subordinated in the waterfall and ranks below the noteholders. The case includes a useful analysis of the applicable English law insolvency principles for distribution of an insolvent company’s assets in relation to such provisions.

The cases referred to are Perpetual Trustee Company Limited v. BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc. and Belmont Park Investments Pty Ltd & Ors Limited v. BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc. [2009] EWHC 1912 (Ch).

The story will not stop here however, as this case concerns the insolvency of Lehman Brothers and the interplay between the English governing law of the applicable documents and United States bankruptcy law. It appears that a US court may yet take a contrary view, leaving the trustee who is responsible for the distribution of assets of the issuers somewhere between a rock and a hard place. The US proceedings are scheduled for October.

The significance of the decision rests in the frequency of the use of similar provisions in rated, listed, asset backed securities.


Lehman Brothers International Europe had established a multi-issuer secured obligation programme under which credit-linked notes were issued to various investors (Noteholders). Lehman Brothers Special Financing Inc. (Lehman BSF) entered into swap agreements with the various issuers in relation to certain notes issued under the programme. These agreements provided that Lehman BSF would pay to each issuer the amounts that issuer had to pay to the Noteholders in return for the issuer paying to Lehman BSF the yield on the collateral backing the applicable notes. The issuers’ obligations to pay Lehman BSF under the swap agreements were also secured on the collateral backing the notes.

In 2008, unable to pay their debts as they fell due, both Lehman BSF and Lehman Brothers Holding Inc. (the credit support provider in relation to the swaps) applied for Chapter 11 bankruptcy protection in the United States. Either one or both of these events constituted an event of default under the swap documentation. As a consequence, the security over the collateral became enforceable.

Perpetual and Belmont, either as or on behalf of the Noteholders, issued proceedings against BNY Corporate Trustee Services Limited (BNY) in its role as trustee. The action was intended to force BNY to realise the collateral and apply the proceeds of the collateral in favour of the Noteholders, crucially, in priority to any claim of Lehman BSF.

Clause 5.5 of the supplemental trust deed applicable to the notes (Supplemental Trust Deed) provided that:

The Trustee shall apply all moneys received by it under this Deed in connection with the realisation or enforcement of the Mortgaged Property as follows: Swap Counterparty Priority unless (i) an Event of Default […] occurs under the Swap Agreement and the Swap Counterparty is the Defaulting Party […] in which case Noteholder Priority shall apply.”

Lehman BSF intervened on the basis that clause 5.5 of the Supplemental Trust Deed (governed by English law) was invalidated by the public policy principle recognised in the British Eagle case (as to which see below).

Lehman BSF also issued proceedings in the United States against BNY, arguing that certain provisions of the arrangements breach the US version of the pari passu principle. Accordingly, Lehman BSF asked the court to stay the English proceedings pending resolution of the US proceedings. The hearing of these proceedings is scheduled for October.

Insolvency Law Overview

Various authorities on both the application and interpretation of insolvency law were considered. The most important are as follows.

In British Eagle International Airlines Ltd v Cie Nationale Air France [1975] 1 WLR 758 the House of Lords held that contracting out of mandatory insolvency law provisions for the payment of unsecured debts pari passu is contrary to public policy and renders such contractual terms unenforceable.

In Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd [2002] 1 WLR 1150A, a contract under which the unlimited interest of a party in an asset was terminated by virtue of the insolvency of another party was ruled void. The Court stated the following principle (anti-deprivation principle):

there cannot be a valid contract that a man’s property shall remain his until bankruptcy, and on the happening of that event go over to someone else, and be taken from his creditors.”

In Ex parte Mackay (1873) LR 8 Ch App 643, the trustee in bankruptcy of a party to a contract claimed a provision entitling another contracting party to retain all royalties due under a contract upon the insolvency was void. The Court of Appeal concurred, stating:

a person cannot make it part of his contract that, in the event of bankruptcy, he is then to get some additional advantage which prevents the property being distributed under the bankruptcy laws.”


Broadly, the issue for the court was whether under English law the change in the order of priority of payment triggered by Lehman Brothers’ default under the swap agreements was valid.

  • Specifically, the court considered each of the following:
    • The anti-deprivation principle
    • Application of the pari passu principle / insolvency process in England Change in priority caused by an event other than insolvency
    • Stay in proceedings


Anti-Deprivation Principle Lehman BSF argued that clause 5.5 of the Supplemental Trust Deed was a clear case of forfeiture of assets by condition subsequent (i.e. the insolvency of Lehman BSF), if the Collateral was insufficient to meet the Noteholders’ and Lehman BSF’s claims then Lehman BSF’s creditors would be prejudiced by the switch of priority as this would have the effect of reducing the assets available for distribution to them. This, it argued, fell within the Money Markets formulation of the principle and so was invalid.

The claimants argued that the courts draw a distinction between (i) a contract which because of insolvency seeks to remove an asset from the estate of the insolvent which was part of that estate when the insolvency commenced and (ii) a contract in which the interest of the insolvent is limited, to cease on its insolvency. Further, the claimants argued that Lehman BSF’s interest in the collateral was only a right, both before and after its insolvency, to compel the trustee to distribute the proceeds as specified in the Supplemental Trust Deed.

The court decided that clause 5.5 of the Supplemental Trust Deed was not void as being contrary to public policy, nor was it inconsistent with the authorities, because the structure as a whole should be examined, not just the wording of clause 5.5 in isolation. Analysing the deal as a whole shows that the collateral was bought by each issuer with noteholders’ subscription monies. The collateral was “in no sense derived directly or indirectly from… the swap counterparty”.

From a commercial perspective, it was understandable that Lehman BSF would have security for the issuers’ obligations under the swap agreements in priority to the noteholders as long as it was performing its side of the agreement.

The intention of the parties was that Lehman BSF’s priority position was “limited and conditional” on LBC continuing to perform its obligations under the swap agreements. Lehman BSF’s priority “never extended to a time after an event of default in respect of which it [Lehman BSF] was the defaulting party had occurred”. The drafting of the agreements reflected this reality.

Any beneficial interest that Lehman BSF had in the collateral was, as to its priority, always limited and conditional. As such, it could never have passed to Lehman BSF’s liquidator or trustee in bankruptcy free from those limitations and conditions as to its priority.

The court was particularly careful not to be seen as interpreting arm’s length commercial transactions so as to invalidate them, especially where such an interpretation would have a very significant impact on many other long-standing commercial arrangements.

Application of the Pari Passu Principle / Insolvency Process in England Although the court opined on this, the decision on the anti-deprivation principle rendered consideration of this issue redundant.

Change in priority caused by event other than insolvency Although the court opined on this, the decision on the anti-deprivation principle rendered consideration of this issue redundant.

Stay in Proceedings Under the transaction documents the trustee was entitled to an indemnity prior to realising and distributing the collateral. As the form of the indemnity was to be agreed at a further hearing listed for after October 2009, the court did not need to decide whether to stay the English proceedings, the stay application was adjourned.


Perhaps unsurprisingly, it has been reported that Lehman BSF will appeal the decision of the High Court. Parties taking comfort in reliance on provisions of this sort will be relieved that the English court upheld their validity. However, there are considerable areas of uncertainty still remaining.

Of particular significance is whether an appeal will be successful and the degree to which an English court will have regard to any judgment of a Bankruptcy Court in the United States. Lehman Brothers argued that the decision of the High Court should take into account any decision yet to be given on the same point by the US Bankruptcy Court. However, the Court decided that, having adjourned the proceedings (until at least 1 October 2009), it could not determine questions raised by the multi-jurisdictional insolvency of Lehman Brothers.

The court considered that the length of the adjournment would provide sufficient time for the US Bankruptcy Court to determine Lehman Brothers’ complaint (in light of the decision of the English court that the noteholder priority provisions of the trust deed were valid under English law) and for the foreign insolvency officials to decide upon any further action they wish to take in connection with the collateral in the context of Lehman Brothers’ insolvency.

It is also worth noting that at the end of August, in the case of The Joint Administrators of WW Realisation 8 Ltd (formerly named Woolworths Media Plc) and Woolworths Group Plc v. BBC Worldwide Ltd, 2 Entertain Ltd and BBC Video Ltd [2009] EWHC 1954 (Ch) another case in which the anti-deprivation principle was considered, the judge was asked to consider the decision in the Perpetual case. He duly did so and expressly disagreed with certain of the obiter statements in that judgement. Whilst it might appear that the cases come to conflicting conclusions, they were decided on differing points and very different facts. The Perpetual case was decided on the basis that the priority position of Lehman BSF was limited to no Lehman BSF default having occurred, and was not a case of forfeiture of assets by condition subsequent, which would have contravened the principle.

In contrast, the WW Realisation case, which related to the termination of a licence agreement upon the insolvency of one of the Woolworths group companies and the subsequent valuation of shares of the parent of the licensee, turned on whether the relevant provisions were saved by the fact that it was not actually the contracting party which became insolvent at the relevant time but its parent company. Here, the judge took a broad view: he supposed that the contracting party must also have been insolvent at the relevant time and looked at the whole effect of the contractual provisions in the round and their resulting effect on the creditors of the insolvent company. This was a much clearer case of the creditors being deprived of value that they would otherwise have had upon an insolvency than the Perpetual case. There, in fact, it was the priority of payments to the insolvent party which was varied upon the default, and not the deprivation of an asset at all as the payment obligations themselves remained.