On January 25, Judge Peck of the U.S. Bankruptcy Court for the Southern District of New York entered a declaratory judgment in favor of Lehman Brothers Special Financing Inc. (LBSF) in a case examining a collateralized debt obligation (CDO) transaction and concerning the effect of event of default provisions on the payment priorities of LBSF as swap counterparty under certain swap agreements and the holders of certain credit-linked synthetic portfolio notes. The payment waterfalls (Priority Provisions) of most CDO transactions give priority to swap counterparties over noteholders. In many cases, the priority is “flipped” and noteholders then receive priority when there is a swap counterparty default. Judge Peck’s recent decision may preclude enforcement of such “flip” priorities in the bankruptcy of the swap counterparty.

The bankruptcy court held that (1) the “flip clauses” in the Priority Provisions at issue in the LBSF case, which sought to modify LBSF’s payment priority following its insolvency, constitute unenforceable “ipso facto” clauses that violate sections of the Bankruptcy Code, and (2) any action to enforce such provisions would violate the automatic stay under the Bankruptcy Code. (Lehman Brothers Special Financing, Inc. v. BNY Corporate Trustee Services, Ltd., Case No. 08-13555, Adv. No. 09-01242 (January 25, 2010))

Trustees of similar transactions may have difficulty navigating the legal landscape with respect to flip clauses as Judge Peck’s ruling directly contradicts a ruling handed down by UK courts in July 2009.