A Flip on the Flip Clause: Lehman Court Changes Course on Flip Provisions and Financial Safe Harbors

by Reed Smith
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New York bankruptcy judge dismisses claims to recover approximately $1 billion that had been distributed to noteholders following commencement of the Lehman Brothers chapter 11 proceedings in September 2008.

After more than six years – and to the relief of financial markets – a court has finally re-examined the controversial decision of Lehman Bros. Special Fin. Inc. v. BNY Corp. Trustee Servs. Ltd., 422 B.R. 407 (Bankr. S.D.N.Y. 2010) (“BNY”). On June 28, 2016, United States Bankruptcy Judge Shelly Chapman issued a lengthy decision rejecting the rationale of her predecessor, Bankruptcy Judge James Peck, and helping to dispel some of the uncertainty that the BNY decision generated in the markets for collateralized debt obligations (“CDO”) and other structured-finance deals. Lehman Bros. Spec. Fin. Inc. v. Bank of America Nat’l Assoc., et al. (In re Lehman Brothers Holdings Inc., et al.), Adv. Pro. No. 10-03547 (SCC), 2016 Bankr. LEXIS 2405 (Bankr. S.D.N.Y., June 28, 2016).

Lehman’s Claims On September 14, 2010, Lehman Brothers Special Financing Inc. (“LBSF”), an indirect subsidiary of Lehman Brothers Holdings Inc. (“LBHI”), commenced an adversary proceeding against 250 noteholders, note issuers, and indenture trustees seeking to recover approximately $1 billion that had been distributed to the noteholders following the commencement of the Lehman Brothers chapter 11 proceedings in September 2008. LBSF argued that distributions made by the indenture trustees of these CDOs could be clawed back from the noteholders because the funds should have been paid to LBSF as the counterparty under credit default swaps (the “Swaps”) with the issuers.

LBSF sold these Swaps to the special-purpose entities (“Issuers”) of 44 synthetic CDOs that LBHI had structured and marketed before its bankruptcy filing in September 2008. In each of these transactions, the indenture trustees held collateral that was the subject of competing priority claims by the noteholders (who claimed it secured the Issuers’ obligation to repay their notes) and LBSF (who claimed it secured the Issuers’ obligations under the Swaps). The transaction documents included “waterfall” provisions governing the payment priority upon the liquidation of the collateral after termination of the Swap (the “Priority Provisions”). LBSF argued that the Priority Provisions were ipso facto clauses that were unenforceable under sections 365(e)(1), 541(e)(1), and 363(l) of the Bankruptcy Code.

The defendant noteholders and indenture trustees moved to dismiss the complaint, arguing that (i) the Priority Provisions were not unenforceable ipso facto clauses because they did not modify LBSF’s rights as a consequence of its bankruptcy, and (ii) even if the Priority Provisions were ipso facto clauses, the distributions were protected by the financial safe harbor provisions of the Bankruptcy Code.

The Decision The Bankruptcy Court classified the Priority Provisions according to the contractual priority provisions. In so-called Type 1 transactions, if LBSF was “in-the-money,” LBSF had an automatic right to receive its Swap termination payment ahead of payments to the noteholders, but such priority was lost when LBSF defaulted on the Swaps. The Bankruptcy Court held that the waterfall in Type 1 transactions modified LBSF’s rights and, therefore, these were unenforceable ipso facto clauses.

By contrast, in Type 2 transactions, the Priority Provisions did not establish a default priority if LBSF was in-the-money; the priority was not fixed until the Swap was actually terminated. LBSF’s payment priority would only arise upon early termination of the Swap if certain conditions existed. One of those conditions was that early termination was not the result of LBSF’s default under the Swap. In each Type 2 transaction, the early termination of the Swap was the result of LBSF’s default. In these transactions, LBSF never had a payment priority and therefore the Bankruptcy Court held that the Priority Provisions were not unenforceable ipso facto clauses. The court also held that even assuming the opposite conclusion with respect to the Priority Provisions in Type 2 transactions, any such modification occurred before the commencement of LBSF’s bankruptcy case and, therefore, would not have violated the ipso facto provisions of sections 365(e), 541(e)(1), or 363(l) of the Bankruptcy Code. In doing so, the Bankruptcy Court expressly rejected the “singular event theory” enunciated in BNY.1 The Bankruptcy Court ruled that a modification that occurred before the LBSF petition date is not prohibited by sections 365(e)(1), 541(e)(1), and 363(l) of the Bankruptcy Code.

Finally, the Bankruptcy Court held that even if the Priority Provisions were unenforceable ipso facto provisions, the safe harbor provisions in section 560 of the Bankruptcy Code protected the distributions from clawback. The Bankruptcy Court conducted its analysis from the perspective that “a broad reading of the safe harbors is consistent, and goes hand-in-hand, with congressional intent in creating (and subsequently expanding) the safe harbors to promote the stability and efficiency of financial markets.”2 The enforcement of the Priority Provisions and the distributions to the noteholders constituted the exercise of a right to cause the “liquidation, termination, or acceleration” of a swap agreement. Furthermore, the enforcement of the Priority Provisions was a right of the Issuers, who indisputably meet the definition of “swap participants.” The Bankruptcy Court therefore dismissed the clawback claims with prejudice.

Conclusion Judge Chapman’s decision is a welcome respite from the uncertainty that followed the BNY decision. Nevertheless, it must be greeted with caution since it does not reverse BNY, although it “respectfully departs” from some of BNY’s reasoning. The result is two inconsistent rulings from two judges presiding over the same bankruptcy cases. This latest opinion is in many ways a more comprehensive and better reasoned analysis of some complex issues. However, until an appellate court reconciles these rulings, any celebration should be muted.


  1. In BNY, the court had treated the bankruptcy filings by LBHI on September 15, 2008, and by LBSF on October 3, 2008, as if they were a “singular event.” As a consequence, it concluded that LBSF was entitled to invoke the protections of the ipso facto provisions retroactively to the LBHI petition date, which was 18 days prior to the LBSF petition date. BNY, 422 B.R.at 419-20.
  2. Lehman Bros. Spec. Fin. Inc. v. Bank of America, at 37, 2016 Bankr. LEXIS at 59-60.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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