The Lehman "flip clause" is back in court. On February 8, 2012, a second group of investors (Belmont Park) in certain synthetic CDOs structured and marketed by affiliates of Lehman Brothers filed suit in the US Bankruptcy Court for the Southern District of New York (Lehman Court) seeking to enforce a provision that was ruled unenforceable by the same court in 2010.

The provision lowered the payment priority of another Lehman affiliate (LBSF), as swap provider for the CDO, in the CDO's payment waterfall as a result of LBSF's bankruptcy filing. However, in 2010 Judge Peck ruled that the flip clause was unenforceable in a US bankruptcy proceeding. In an analogous proceeding, the English High Court reached the opposite result applying English insolvency law. The Belmont Park investors are now seeking to enforce the UK judgment in the US.

The 2010 case settled after the Lehman Court's ruling was appealed. Lehman had an incentive to settle that case even though it had been successful in the bankruptcy court because the ruling strengthened its position in a number of other similar actions that hinge on the same issue. This new lawsuit threatens to upset that ruling. The other Lehman flip clause cases have been stayed pending resolution of the cross-border issue in this case.

LBSF served as swap provider to the transactions, entering into credit default swaps with issuers of the CDO notes. In synthetic securitizations such as those at issue in this case, the swap provider makes credit protection payments to the issuer under an agreed pool of CDS. These payments are used to pay the investors principal and interest on the notes.

A flip clause is a standard provision included in most securitizations, including synthetic CDOs, usually in the transaction's indenture. Flip clauses are designed to subordinate swap payments when the swap provider defaults under the swap agreement. When LBSF filed for bankruptcy, the flip clause in the CDO documentation was triggered. In this case, an enforceable flip clause would mean that noteholders would be entitled to a priority claim to any collateral held by the trustee to satisfy the issuer's obligations to them under the notes before Lehman would be entitled to be paid for its duties as swap provider out of any proceeds of that collateral.

In 2010, the SDNY Bankruptcy Court held in Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd. (BNY) that the flip clause was unenforceable because it would have altered the debtor's payment distribution priority based on its bankruptcy filing, making it a prohibited ipso facto clause under sections 365(e) and 541(c) of the Bankruptcy Code (see Legal Update, US decision in Perpetual case creates a cross-border conflict). An analogous proceeding before the English High Court reached the opposite result and found that the flip clause was enforceable under English insolvency law (see Legal Update, UK Supreme Court Confirms Enforceability of Flip Clauses in Belmont Park (Perpetual) Decision).

The Belmont Park investors request that the Lehman Court:

The investors argue that, contrary to the earlier ruling of the Lehman Court in BNY, the flip clause should not activate sections 365(e) and 541(c) of the Bankruptcy Code. Even if those sections would otherwise be triggered in this instance, the investors argue that the safe-harbor provisions of the Bankruptcy Code prevent them from being applicable.

The investors also filed a companion motion, alleging that the issues before the court are tangential to the Lehman bankruptcy and asking the US District Court for the Southern District of New York to "withdraw the reference." If granted, this would transfer the case from the bankruptcy court to the district court. The investors are looking to have the case heard in a venue other than the one that has already ruled the flip clause unenforceable against the debtor in a US bankruptcy.

The conflicting decisions create a transatlantic disparity in which US law favors the debtor swap provider and UK law favors investors. The case has the greatest implications for synthetic securitizations but impacts all securitizations subject to US law to some degree.

For a more detailed description of the technical issues involved in this case, such as the flip clause and the role of the swap provider and CDS in synthetic CDOs, see Legal Update, Lehman Court Holds BNY/Perpetual Securitization Swap-Payment Provision Unenforceable.

For more information about the safe harbors for certain types of agreements under the Bankruptcy Code, see Article, Lehman-Swedbank Decision Holds that Mutuality Must Exist to Exercise Right of Setoff Under Swap: Quick and Easy Guide to Bankruptcy Code Safe Harbors.

For more information on this and other current developments in securitization, see Practice Note, Current Developments in Securitization: Overview.

For more information on the swap provider, the issuer and other parties to a securitization, see Practice Note, Securitization: US Transaction Parties and Documents.

For more information on synthetic securitizations, as well as an explanation of CDOs and other types of securitizations, see Practice Note, Securitization: US Overview.