In our prior bulletin, we discussed the July 6, 2016 decision of Judge Shelly Chapman of the United States Bankruptcy Court for the Southern District of New York in In re Lehman Brothers Holdings Inc., 553 B.R. 476 (Bankr. S.D.N.Y. 2016), which rejected existing precedent in the Lehman bankruptcies regarding the application of the ipso facto and safe harbor provisions of the Bankruptcy Code. Among other things, Judge Chapman rejected the "singular event" rationale, whereby non-debtor affiliates of Lehman Brothers Holdings Inc. were deemed to have the benefit of the anti-ipso facto provisions of the Bankruptcy Code upon its chapter 11 bankruptcy filing on September 15, 2008, and endorsed a broader construction of the safe harbor provisions of the Bankruptcy Code. Until Judge Chapman’s decision, prior authority in the Lehman cases had served as a basis to prevent the enforcement of so-called "flip clause" provisions that purported to alter Lehman’s priority to certain collateral in the event of a Lehman bankruptcy.
On March 14, 2018, U.S. District Judge Lorna G. Schonfield of the United States District Court for the Southern District of New York in Lehman Brothers Special Financing Inc. v. Bank of America National Association, et al. (In re Lehman Brothers Holdings Inc.), No. 17 Civ. 1224 (LGS), 2018 WL 1322225 (S.D.N.Y. March 14, 2018) (the District Court Decision) affirmed Judge Chapman’s decision in a well-reasoned opinion that did not address the "singular event" rationale but nevertheless supported a broad construction of the safe harbors, finding that the distribution of collateral proceeds in accordance with "flip clauses" would be protected as part of the "liquidation" of a swap agreement within the meaning of section 560 of the Bankruptcy Code.
Background
As discussed in our prior eAlert, Lehman Brothers Special Financing Inc. (LBSF) was party to numerous swap transactions with special purpose entities in connection with their issuance of collateralized debt obligations. The issuers’ obligations to LBSF under the swap transactions and their obligations to noteholders under the collateralized debt obligations were secured or supported in each case by a common pool of collateral.
A default by LBSF, such as the September 15, 2008, bankruptcy filing of its parent, Lehman Brothers Holdings Inc. (LBHI), would result under the terms of the documents in the subordination of LBSF’s claim to payment from the proceeds of such collateral to the claims of noteholders. LBSF itself filed for bankruptcy on October 3, 2008, and subsequently commenced adversary proceedings seeking to recover payments made to noteholders under the theory that the subordination provisions were unenforceable ipso facto clauses under Sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code.
Judge Chapman rejected this argument and held, contrary to prior decisions rendered in the Lehman bankruptcies, that: (i) certain of the subordination clauses at issue were ipso facto clauses while others were not; (ii) Sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code could not render unenforceable ipso facto clauses that were triggered prior to LBSF’s bankruptcy filing; and (iii) distributions to noteholders made pursuant to the subordination clauses at issue were, in any event, protected by the safe harbor provision of Section 560 of the Bankruptcy Code.
LBSF and LBHI appealed.
The District Court Decision
Contrary to Bankruptcy Judge Chapman, District Judge Schonfield did not decide whether the subordination clauses were ipso facto clauses or whether Sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code could be applied to contract rights that were exercised before LBSF filed for bankruptcy. Judge Schonfield instead held more broadly that the subordination clauses were protected by Section 560 of the Bankruptcy Code, which she described as providing "a safe harbor protecting a swap participant’s right to unwind a swap transaction pursuant to an ipso facto clause that otherwise would be unenforceable" and allowing for "[t]he exercise of any contractual right of any swap participant . . . to cause the liquidation [or] termination . . . of one or more swap agreements" notwithstanding the anti-ipso facto provisions of the Bankruptcy Code.
Judge Schoenfield held that distributions made to noteholders constituted the exercise of a contractual right to cause the "liquidation" or "termination" of a swap agreement, as explicitly protected by Section 560 of the Bankruptcy Code, finding that ending the swap agreements by distributing the collateral pursuant to the subordination clauses fell within the plain meaning of the word "liquidation." Further, she observed that the "purpose of [Section] 560 is to protect securities markets from the disruptive effects that unwinding swap transactions in bankruptcy would cause," and that construing "liquidation" to cover merely the calculation of amounts owed, but not the distribution of assets to satisfy such obligations, would produce an absurd result by "provid[ing] no security to swap participants if they will not be able to collect on those debts."
Judge Schoenfield also rejected an argument made by LBSF and LBHI that Section 560 only protects the exercise of contractual rights by the actual party to a swap agreement, as a "swap participant" under the Bankruptcy Code (i.e., an issuer), and not the exercise by an agent or trustee for such party (i.e., a trustee that actually held and distributed the collateral under each structure). She concluded that "Section 560 requires only the exercise ‘of’ a swap participant’s contractual right, but that right need not be exercised ‘by’ the swap participant."
Conclusion
While the District Court Decision is more limited than Judge Chapman’s decision and does not address certain holdings regarding the interpretation of the ipso facto provisions of the Bankruptcy Code, it nonetheless endorses a broad reading of the safe harbors of the Bankruptcy Code that should provide some comfort to parties seeking to enter into similar transactions involving the use of "flip clause" provisions under swap agreements.
1 District Court Decision at 8.
2 11 U.S.C. § 560.
3 District Court Decision at 10.
4 District Court Decision at 12.
5 District Court Decision at 9 & 12.
6 District Court Decision at 14.
