US Bankruptcy Court Enforces CDO Transaction Flip Clauses | White & Case LLP International Law Firm, Global Law Practice
US Bankruptcy Court Enforces CDO Transaction Flip Clauses

US Bankruptcy Court Enforces CDO Transaction Flip Clauses

THE DELTA REPORT
Derivatives Newsletter
September 2016

Read other articles
in this issue

Download full PDF
of this issue

Search for more
Derivatives Insights

US Bankruptcy Court holds that insolvency-related provisions setting the priority of payment under various structured finance transactions were enforceable and the distributions were protected by the US Bankruptcy Code safe harbours.

 

Introduction

On 28 June 2016, the US Bankruptcy Court for the Southern District of New York (the "Court") decided, in Lehman Brothers Special Financing Inc. v. Bank of America National Association, et al,1 that provisions set out in various synthetic collateralized debt obligation ("CDO") transactions that altered the priority of payments following the occurrence of certain specified insolvency events were enforceable and the distributions made under such provisions were protected by the US Bankruptcy Code safe harbours.

This Court declined to adopt the reasoning of Judge Peck in earlier rulings in the same case, in Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd. (In re Lehman Bros. Holdings Inc.)2 ("BNY") and Lehman Brothers Special Financing Inc. v. Ballyrock ABS CDO 2007-1 Ltd. (In re Lehman Bros. Holdings Inc.)3 ("Ballyrock"), which invalidated similar CDO provisions that subordinated swap termination payments upon the occurrence of certain specified insolvency events.

This article sets out a summary of this decision.

 

The CDO Transactions

The transactions at issue were a series of CDO transactions. Although the CDO transactions had varied terms in certain respects, they all had the same general structure:

(a) An issuer issued one or more series of notes (the "Notes") to a group of noteholders (the "Noteholders") and used the proceeds to purchase certain liquid investments to provide investment income and serve as collateral (the "Collateral").

(b) The issuer entered into one or more swaps with Lehman Brothers Special Financing Inc. ("LBSF") whereby the issuer sold synthetic credit protection to LBSF on certain reference entities (each, a "Swap"). The issuer used the premium payments received from LBSF to enhance the interest payments to the Noteholders under the Notes.

(c) The Collateral was used to secure or support the issuer's obligations to the Noteholders under the Notes and to LBSF under the Swaps. The Collateral was held in trust by a trustee and the trustee held a lien on the Collateral for the benefit of the Noteholders, LBSF and other specified secured parties. All payments from the Collateral were to be made by the trustee pursuant to the priority of payment provisions that became the subject of the litigation.

(d) Lehman Brothers Holding Inc. ("LBHI") guaranteed LBSF's obligations under each Swap and was designated as a "credit support provider" under the Swaps documentation.

 

The Lehman Bankruptcies

On 15 September 2008 LBHI filed for bankruptcy protection ("LBHI Petition Date") and on 3 October 2008 LBSF filed for bankruptcy protection ("LBSF Petition Date"), in each case, under Chapter 11 of the US Bankruptcy Code.

As a result of LBHI bankruptcy petition filing, the payment obligations under the Notes were accelerated, the vast majority of the Swaps were terminated and the Collateral was liquidated and distributed in accordance with the priority of payment provisions (see below). Because LBHI was a "credit support provider" of LBSF under the Swaps, the bankruptcy filing of LBHI resulted in an event of default under the Swaps permitting the issuers to terminate the Swaps prior to the LBSF Petition Date. A handful of Swaps were terminated after the LBSF Petition Date.

 

The Priority of Payment Provisions

If an event of default occurred under the terms of the Notes, an enforcement notice could be delivered by the trustee accelerating the payments due and owing under the Notes, triggering an early termination of the Swaps and permitting the Collateral to be liquidated with any proceeds then required to be distributed in accordance with the applicable priority of payment provisions. It is the priority of payment provisions that were central to this decision.

The CDO transactions used two different priority of payment provisions:

(a) Under the first type, LBSF held a right to payment in priority ahead of the Noteholders that was fixed at the outset of the CDO transaction. However, if the conditions for an alternative priority were satisfied after this time, LBSF would lose its payment priority. CDO transactions with these provisions were referred to by the Court as "Type 1 Transactions". Of the CDO transactions considered, only five were Type 1 Transactions.

(b) Under the second type, the priority of payment was not fixed at the outset of the CDO transaction, but instead had two potential priorities that could become applicable. One of the options gave priority to LBSF whilst the other gave priority to the Noteholders. LBSF did not have a right to payment priority ahead of the Noteholders, only a right to be paid proceeds of the Collateral pursuant to one of the applicable provisions. Which priority applied would remain unknown until a default occurred and the circumstances surrounding it were determined. CDO transactions with these provisions were referred to by the Court as "Type 2 Transactions". The vast majority of the CDO transactions were Type 2 Transactions.

Importantly, both types of priority of payment provisions provided that, where an early termination of the Swaps occurred as a result of the bankruptcy of LBHI or LBSF, the Noteholders held payment priority ahead of LBSF. As a result of the bankruptcy filings of LBHI and LBSF, the priority of payment provisions giving the Noteholders priority ahead of LBSF were applied. The proceeds of the liquidation of the Collateral were insufficient to make any payments to LBSF.

Although the practical effect of the priority of payment provisions under the Type 1 Transactions and the Type 2 Transactions were the same, the differences in how these provisions were drafted (as set out above) was a material factor in the Court's decision.

 

Were the priority of payment provisions unenforceable ipso facto clauses?

Anti-ipso facto provisions

Under the US Bankruptcy Code, an ipso facto clause is a one that modifies the rights of a debtor due to the filing of a bankruptcy petition by a debtor. Such clauses are generally unenforceable pursuant to Sections 365(e), 541 and 363(1) of the US Bankruptcy Code (these provisions were collectively referred to in the Court's decision as the "anti-ipso facto provisions"). For example, Section 365(e) relevantly provides as follows:

an executory contract … of the debtor may not be terminated or modified, and any right or obligation under such contract … may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract … that is conditioned on … the commencement of a case under this title … .

Based on a review of the anti-ipso facto provisions, the Court stated that in order to determine whether the priority payment provisions constituted ipso facto clauses it would need to consider three factors:

  1. the nature of the rights held by LBSF prior to the relevant Swap early termination date;
  2. whether the enforcement of the priority of payment provisions modified any right of LBSF; and
  3. if there was a modification, when such modification occurred.

The Court analysed both the Type 1 Transactions and Type 2 Transactions against these three factors.

Type 1 Transactions

The Court concluded that, because LBSF held a right to payment of priority ahead of the Noteholders that was fixed from the outset of the Type 1 Transactions, the subsequent removal of that right because of LBSF's default due to its bankruptcy filing was, absent any safe harbour protection, unenforceable as an ipso facto clause.

Type 2 Transactions

The Court concluded that, because LBSF never held a right to payment of priority ahead of the Noteholders and instead only held a right to receive the Collateral pursuant to the then prevailing priority of payment, the subsequent application of the payment of priority that gave priority to the Noteholders ahead of LBSF did not modify an existing right. Therefore, the priority of payment provisions were not an ipso facto clause and were enforceable.

The Court noted that, even if it had decided differently that the rights of LBSF were modified, the fact that such modifications for the majority of the CDO transactions occurred before the LBSF Petition Date meant that the priority of payment provisions did not violate the anti-ipso facto provisions as these provisions only apply where a modification of rights occurs after a debtor's bankruptcy filing (which, in this case, was the LBSF Petition Date). Because, under each Type 1 Transaction, the termination of the related Swaps, the liquidation of the Collateral and the distribution of proceeds occurred after the LBSF Petition Date, the Court's alternative holding did not apply to the Type 1 Transactions.

The Court declined to adopt the so-called "singular event" theory set out by Judge Peck in BNY. Under this theory, the LBSF Petition Date and LBHI Petition Date would have been treated as a single event with the result that the relevant bankruptcy filing date for the purposes of the anti-ipso facto provisions would have instead been the earlier LBHI Petition Date (i.e., 15 September 2008, not 3 October 2008). The Court therefore confirmed that only LBSF's bankruptcy filing mattered for the analysis of the anti-ipso facto provisions and thus the LBSF Petition Date was the applicable date, and not the LBHI Petition Date as it was the rights of LBSF as counterparty to the Swaps that were at issue, not those of LBHI.

 

Was a US Bankruptcy Code safe harbour available?

After finding that the Type 2 Transactions did not violate the anti-ipso facto provisions, the Court turned to whether the Type 1 Transactions, which violated such provisions, were nonetheless subject to a US Bankruptcy Code safe harbour.

Section 560 of the US Bankruptcy Code provides that the exercise of any contractual right of any swap participant or financial participant to cause the liquidation, termination or acceleration of a swap agreement shall not be stayed, avoided or otherwise limited by any provision of the US Bankruptcy Code or any court order (the "Swap Bankruptcy Safe Harbour").

In declining to adopt the rulings of Judge Peck in BNY and Ballyrock, the Court noted that the safe harbours contained in the US Bankruptcy Code (including the Swap Bankruptcy Safe Harbour) are to be interpreted broadly and literally. In the Court's view, this was consistent with its prior decisions which emphasised that the various safe harbours are intended to protect the stability and efficiency of the financial markets.

In light of this, the Court made the following three findings:

  1. First, the use of the terms "termination" and "liquidation" therein should be interpreted to have two distinct meanings – the term "termination" covered the actual termination of the Swaps and the term "liquidation" was broad enough to cover the subsequent liquidation of the Collateral as well as the distribution of the proceeds pursuant to the priority of payments. It was not a relevant consideration that the priority of payments in effect gave the Noteholders priority ahead of LBSF.
  2. Second, because the priority of payment provisions were either explicitly part of the Swaps documentation or incorporated through schedules, they formed part of the Swaps and were therefore rights of "swap participants".
  3. Third, the enforcement of the priority of payment provisions was a right of the issuers, being counterparties to the Swaps and therefore "swap counterparties", that was protected by the Swap Bankruptcy Safe Harbour. The fact that the termination of the Swaps and the liquidation and distribution of the Collateral were rights that could be exercised by the issuer was sufficient for those rights to be protected, notwithstanding that it was the trustee, acting on behalf of the issuers, who actually exercised such rights.

The Court therefore concluded that enforcement of the priority of payment provisions satisfied the elements of the Swap Bankruptcy Safe Harbour and thus those provisions could not be stayed, avoided or otherwise limited by the US Bankruptcy Code (including by application of the anti-ipso facto provisions) or any court order. Therefore, even though the priority of payment provisions in the Type 1 Transactions were in theory unenforceable under the anti-ipso facto provisions, the distributions made pursuant to such provisions were nonetheless enforceable through by the Swap Bankruptcy Safe Harbour. The same conclusion would also apply to the Type 2 Transactions, although as the priority of payment provisions applicable to such transactions were enforceable (i.e., they were not caught by the anti-ipso facto provisions) the distributions were already protected.

 

1 Ch. 11 Case No. 08-13555, Adv. No. 10-03547 (Bankr. S.D.N.Y June 28, 2016).
2 422 B.R. 407 (Bankr. S.D.N.Y. 2010).
3 452 B.R. 31 (Bankr. S.D.N.Y. 2011).

 

This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2016 White & Case LLP