The controversy dealt with distributions made to noteholders after the termination of the swap agreements. The swap agreements included the bankruptcy of Lehman Brothers Special Financing Inc. (“LBSF”) or LBHI (as a guarantor of LBSF’s obligations under the swaps) as an event of default under which special purpose vehicles, as the issuers, could unwind the swap agreements and repay the noteholders from the collateral. Upon the bankruptcy filing of LBHI1, the collateral was liquidated and distributions were made to the noteholders, who received payment priority over LBSF since LBSF was the defaulting party under the swap agreements. The proceeds from the collateral were insufficient to make any payments to LSBSF.
LBSF sued the noteholders to recover the payments in 2010, claiming that the event of default in the swap agreements, which subordinated LBSF’s payment upon its default, was an improper “ipso facto” clause. An ipso facto clause is generally unenforceable in bankruptcy due to the automatic stay, which halts actions against a debtor or property of the debtor’s estate once a bankruptcy case begins, and because of section 365(e) of the Bankruptcy Code, which among other things, prevents the termination of executory contracts and unexpired leases due to the commencement of a bankruptcy case.
On appeal, the Second Circuit stated that in order for the safe harbor provision to apply, (i) the priority provisions would have to be part of the swap agreement at issue, (ii) the distribution of collateral would have to constitute a “liquidation,” and (iii) the trustees holding the collateral would have to have exercised a “contractual right of a swap participant.” The panel found that each of the requirements was met in this case.
This ruling could potentially expand the scope of the safe harbor provision. The Second Circuit opted to define “liquidation” as including the settlement of obligations through distribution of the proceeds, arguing that the right to liquidate would not be able to serve its purpose if it “merely sheltered [a swap counterparties’] ability to determine amounts owed, but not to distribute the proceeds from the sold collateral.” The panel also upheld the lower court’s ruling that the swap party itself does not have to be the party to exercise the contractual right in order for the transaction to be protected, and an appropriate other party, such as a trustee, can exercise those rights.
Hogan Lovells represented one of the noteholder respondents in this case.
1Notably, the Second Circuit did not reach the issue of whether the bankruptcy filings of LBHI and LBSF should be considered a “singular event” for purposes of default under the swap agreements. Judge James Peck had treated the separate bankruptcy filings as a singular event when interpreting the event of default language in his 2010 decision. Lehman Bros. Holdings Inc. v. BNY Corp. Tr. Servs. Ltd., 422 B.R. 407, 420 (Bankr. S.D.N.Y. 2010). Judge Shelley Chapman subsequently rejected the “singular event theory” in granting the defendants’ motion to dismiss in 2016. Lehman Bros. Special Fin. Inc. v. Bank of Am. Nat’l Ass’n, 553 B.R. 476, 497 (Bankr. S.D.N.Y. 2016).