Most transactional documentation provides for an insolvency event, whether it is in the form of a termination right in respect of a contract or interest, a right to acquire the insolvent’s shares or assets, or a priority agreement. In such cases, it is vital that the provisions do not fall foul of the “anti-deprivation” principle that exists in one form or another in most insolvency regimes. Simply stated, the principle seeks to prevent contracts or arrangements transferring assets, in the event of an insolvency, from the insolvent to a third party at the expense of the general creditors.
The anti-deprivation principle has been the subject of recent consideration in the UK, Australia, Hong Kong and the USA and has, in some instances, resulted in conflicting decisions. In considering the insolvency-related provisions which should be incorporated into any transaction, it is vital to understand how the anti-deprivation principle may operate in different situations and jurisdictions.
In common law jurisdictions, the leading case on the application of the anti-deprivation principle is the decision in British Eagle International Air Lines Ltd v Compagnie Nationale Air France  1 WLR 758 (British Eagle). This decision was considered by the Court of Appeal in Hong Kong in Peregrine Investments Holdings Ltd (In liquidation) v Asian Infrastructure Fund Management Co Ltd CACV 32/2003 (Peregrine) and by the High Court of Australia in IATA v Ansett Australia Holding Ltd  BPIR 57 (Ansett). All these decisions were recently considered by the English Court of Appeal in Perpetual Trustee Company Ltd v BNY Corporate Trustees Services  EWCA 1160 (Perpetual), leading to affirmation of the operation of the anti-deprivation principle in some instances but rejecting its application in Perpetual on the facts. However, on almost identical facts, the decision in Perpetual was not followed by the US Bankruptcy Court in Lehman Brothers Special Financing Inc v BNY Corporate Trustee Services Limited (Case No: 09-01242).
As the British Eagle and Ansett cases demonstrate, the anti-deprivation principle is of particular relevance to the operation of clearing houses. By netting off credits and debits a clearing house avoids the requirement for its members to make and receive as between themselves numerous payments in respect of inter-members’ operations and services. To avoid the operation of the anti-deprivation principle, members of a clearing house agree to waive any right to recover a debt as against an individual member in consideration for the right to pursue any claim against the clearing house, the objective being to ensure that inter-membership debts are not treated as individual assets of the members.
The British Eagle case concerned the operation of IATA, a clearing house for airlines. British Eagle, having carried passengers for Air France, was owed a certain sum by Air France. Following a creditors’ voluntary winding up, British Eagle’s liquidator claimed that such amount was an asset that should be available to its unsecured creditors. Air France contended that nothing was owed directly to British Eagle, and that, under the clearing house system, British Eagle's only relevant assets or liabilities were rights or obligations as between British Eagle and IATA. The House of Lords held by a single majority, overturning the High Court and a unanimous Court of Appeal, that the clearing house arrangement between airlines for the settlement of credits and debts was ineffective to retain for netting off purposes an identifiable debt owed by one airline to another. The decision highlighted a weakness in the clearing house system of recognising the existence of a specific debt owed by one member to another. As a result, IATA’s regulations were amended so as to make clear that, in agreeing to membership, airlines waived any individual inter-member liability. The purpose of the amendment was to ensure that, in the absence of an asset in the form of a debt, there could be no attempt to dispose of or deal with such property in a manner inconsistent with the relevant insolvency laws.
The effectiveness of this amendment was considered in the Australian Ansett decision. In this case, IATA brought a claim against Ansett for netted off claims. As in British Eagle, Ansett sought to contend that the IATA scheme was contrary to the insolvency legislation on public policy grounds. This argument was rejected by a majority of the High Court of Australia on the grounds that neither the insolvency legislation nor public policy required the imposition of a debtor-creditor relationship in circumstances where the members had at the inception of their membership, agreed that they would not enter into such a relationship.
The Hong Kong Peregrine decision involved a shareholders' agreement under which the shares of one of the parties in a management company could be acquired by the others at par value in the event of an affiliate’s insolvency. It was contended that such a provision breached the anti-deprivation rule in relation to the insolvency of the ultimate parent company, notwithstanding, that it was not a party to the shareholders’ agreement and neither its subsidiary nor sub-subsidiary was insolvent. The view of the majority of the Court of Appeal was that the rule did apply to render the provisions unenforceable because removal of its only asset (the shares in the management company) at an undervalue indirectly reduced its value.
The perpetual decision
The English Court of Appeal had to consider the status of the anti-deprivation rule in two separate cases, the first concerning a credit-linked note issued by a Lehman Brothers’ structured issuance vehicle (the Lehman case) and the second a joint venture agreement between BBC World and the Woolworths Group (the BBCW case).
The facts of the Lehman case were as follows:
Lehman Brothers International (Europe) issued to investors, through a bankruptcy-remote SIV (Dante), fixed rate notes (Notes) which were secured by government securities or other secure investments (Collateral) purchased using the proceeds of the Notes.
Another Lehman entity, Lehman Brothers Special Financing Inc. (LBSF), entered into a credit default swap (Swap) with Dante, under which LBSF paid Dante an amount equal to the payments of interest and principal due on the Notes in exchange for sums equal to the yield on the Collateral. The excess of LBSF’s payments over Dante’s effectively constituted a ‘premium’ paid to Dante by LBSF in return for credit protection in respect of the obligations (Obligations) of one or more reference entities.
On maturity, the amount of principal to be returned to the holders of the Notes (funded by LBSF under the Swap) was to be reduced by an amount calculated by reference to any defaults under the Obligations (hence the term ‘credit-linked note’).
The relevant intercreditor documentation contained a ‘flip’ clause which set out two different payment waterfalls; one under which LBSF as Swap counterparty would rank ahead of the holders of the Notes, and one under which, vice versa, the holders of the Notes would rank ahead of LBSF as Swap counterparty. The first waterfall was to apply throughout the life of the transaction, assuming no default by LBSF under the Swap occurred, and the second was only to come into effect on a default by LBSF under the Swap.
The English Court of Appeal held that defaults had occurred in respect of LBSF when (i) its holding company, Lehman Brothers Holdings Inc. (LBHI) (which, for the purposes of LBSF’s obligations under the Swap was named as a Credit Support Provider filed for Chapter 11 protection; and (ii) on the cessation of interest payments. That following such default, according to the ‘flip’ clause, any payments paid out under the transaction from this point onwards should have been paid first to the holders of the Notes, with LBSF only receiving the amount, if any, remaining in the structure once all prior ranking payments under the waterfall had been satisfied.
LBSF’s administrators contended that the operation of the ‘flip’ clause offended the anti-deprivation principle on the grounds that it reduced or limited the economic value of LBSF’s estate. The Court of Appeal rejected this argument on the grounds that the anti-deprivation principle:
- only applied to assets belonging to or vested in the insolvent, which was not the case here as when the ‘flip’ clause was activated, the only insolvent party was LBHI; LBSF did not file for Chapter 11 protection until 3 October 2008;
- did not apply where the deprivor had purchased the assets held by the insolvent (in this case the Collateral had been purchased using the proceeds of the Notes); and
- did not apply where the alleged deprivation was of a contingent right. On the facts of the case, the right of LBSF to enjoy priority over other creditors was contingent on no event of default under the Swap by LBSF having occurred. As soon as such event of default occurred, the right ceased to exist. This ‘flawed asset’ concept is widely recognised in relation to derivatives and is one of the fundamental pillars on which the standard ISDA documentation is based.
One member of the Court of Appeal rested his decision on the grounds that where a charge at its inception agreed to an order of priority it could never amount to a deprivation but the majority took a more restrictive view of the principle. The Court also pointed out that as the Insolvency Act 1986 had in effect codified insolvency law, the Court should be slow to extend extra-statutory principles
The facts of the BBCW case were as follows:
BBC World (BBCW) entered into a joint venture agreement with Woolworths Group plc (Group), the owner of Woolworths, and its subsidiary Woolworths Media plc (Media) through a joint venture vehicle 2e. BBCW owned 60% and Media 40% of the issued shares in 2e. The agreement provided that in the event of an insolvency of Media’s affiliates, BBCW could, by serving purchase notices, acquire Media’s shares in 2e at a fair value. By a licence agreement, BBCW also agreed to grant BBC Video Ltd (Video), a subsidiary of 2e, a licence to exploit catalogue rights which would terminate in the event of BBCW serving a purchase notice. When Group was placed in administration BBCW served purchase notices on Media, which was not yet in administration.
The Court of Appeal held that the termination of Video’s licence did not offend the anti-deprivation principle on the grounds that termination of such a limited interest did not involve property of an insolvent person vesting in the putative deprivor. However, the transfer of Media’s shares in 2e would have fallen foul of the principle but for the fact that the transfer was to be at market value and that the notice had been given prior to Media being placed into administration. Of some relevance to this conclusion was that the purchase price disregarded any discount on account of Media’s minority interest in 2e.
The Court of Appeal refused to follow the Peregrine decision on the grounds that the anti-deprivation principle applied only to the transfer or removal of property belonging to the insolvent and could not be applied to contractual arrangements which had the effect of reducing value but without affecting the ownership of the insolvent’s property. The Court held that unless the circumstances permitted the corporate veil to be pierced, the anti-deprivation rule should be confined to cases where the insolvent’s property, within the meaning of the Insolvency Act, is removed from the insolvent estate either for less than its market value or for no value at all.
The US Bankruptcy Court’s Lehman decision
Significantly, in January 2010 the Lehman decision in Perpetual was not followed by the US Bankruptcy Court. In the US, the case was decided in favour of LBSF on the grounds that the Swap constituted an executory contract and was therefore protected by the safe harbours of s.365 of the Bankruptcy Code, which provides that clauses purporting to terminate or modify contractual rights or interests due to the bankruptcy of a company, otherwise referred to as “ipso facto” clauses, may not be upheld.
In contrast to the Court of Appeal’s analysis of the facts, New York’s Bankruptcy Court held that as an “integrated enterprise”, the filing for Chapter 11 protection at holding company level had at the same time extended such protection to all of LBHI’s subsidiaries, despite the fact that LBSF did not file for Chapter 11 protection until a later date. The Court refused to extend comity to the English decision in Perpetual on the grounds that it would be contrary to the policies and prejudicial to the interests of the United States, although Judge Peck did acknowledge, in handing down his judgment, that “…[the Court] is interpreting applicable law in a manner that will yield an outcome directly at odds with the judgment of the English Courts.”. In handing down such a judgment, the Court demonstrated that US bankruptcy laws, which are generally regarded by legal commentators as being relatively ‘debtor-friendly’, give greater protection to a debtor than either the English and Australian regimes. The application of the anti-deprivation principle in the US ruling was, in many ways, more in line with the decision in Peregrine. Immediate implications of the decision of the US courts appear to be that flip clauses may not be enforceable in circumstances where the relevant transaction has a US nexus (including where the documentation is subject to US law or where the counterparty is a US entity) and may thereby be subject to the jurisdiction of US courts. It has been suggested by various commentators and rating agencies that as a consequence of the US judgment, ratings assigned to existing and future structured finance transactions which have a US nexus may be limited to the rating of the swap counterparty. This in turn may lead to a shift in the structured finance market, with more transactions employing English law, under which courts have upheld the enforceability of ‘flip’ clauses.
An application filed by LBSF for leave to appeal the English Court of Appeal’s judgment to the Supreme Court of England and Wales has been denied. However, the decision of the US court is subject to appeal to the US District Court for the Southern District of New York and the US Court of Appeals for the Second Circuit.
Both jurisdictions appear to be open to the idea of reconciling the differing regimes, and to this end a ‘status conference’ to harmonise the conflicting judgements was originally scheduled to take place on 10 February 2010. Although we understand that this hearing has been postponed, the outcome of any such hearing is likely to affect any appeal made in the US.
As the international decisions indicate, a level of uncertainty surrounds the operation and ambit of the anti-deprivation principle across various jurisdictions and, in particular, whether it should extend to any transfer that indirectly reduces or limits the economic value of the insolvent’s estate. Given the different approaches to the operation of the principle an appreciation of how a particular insolvency jurisdiction may treat the principle is essential.