On April 19, 2012, the US Bankruptcy Court for the Southern District of New York issued a memorandum decision in a Lehman Brothers adversary proceeding that prepetition collateral transfers totaling $8.6 billion made by Lehman to its clearing bank, lender, repo agent and swap counterparty, JPMorgan Chase Bank, N.A. (JPM), in the run-up to Lehman's bankruptcy were protected from avoidance, or recovery, by the Lehman trustee for the benefit of Lehman's creditors by the safe harbor contained in section 546(e) of the Bankruptcy Code. Section 546(e) exempts from avoidance certain transfers made in connection with trading contracts, including margin payments. The court ruled the payments were protected, emphasizing that this was the exact setting for which the safe harbors were designed.

Prior to Lehman's bankruptcy, JPM served as Lehman's principal clearing bank, as well as the agent for Lehman's tri-party repurchase agreements (repos). JPM was also:

In the months leading up to Lehman's bankruptcy, as Lehman's financial condition deteriorated, JPM demanded collateral and other concessions from Lehman in exchange for continuing to supply credit Lehman needed to continue operations. Lehman claimed these concessions and collateral transfers vastly improved JPM's position relative to other creditors, while providing Lehman with little in return.

Lehman filed for bankruptcy in September 2008 and initiated the adversary proceeding against JPM in May 2010 to recover $8.6 billion of collateral it had posted with JPM during the prepetition period under the parties' clearing agreement. Lehman alleged that JPM took unfair advantage of it at a time when it depended on JPM as its main source of prepetition credit to sustain critical trading operations for customers.

In the action, Lehman sought:

In October 2010, JPM filed a motion to dismiss, arguing that the transfers were fully protected from avoidance under section 546(e) of the Bankruptcy Code, which says that a trustee may not avoid a prepetition transfer that is a margin payment or settlement payment made by or to, among other things, a financial institution or financial participant in connection with a securities contract, commodity contract or forward contract.

The key litigated issue was whether the security interests granted, obligations incurred and collateral transfers made by Lehman to JPM in the period prior to Lehman's bankruptcy filing were shielded from avoidance actions by the bankruptcy trustee, as constructively fraudulent transfers and preferential transfers by the safe harbor in section 546(e) of the Bankruptcy Code.

The court granted JPM's motion to dismiss on the counts relating to the safe harbor, holding that section 546(e) of the Bankruptcy Code applies to the prepetition transfers made by Lehman to JPM. Section 546(e) exempts from avoidance, among other things, margin payments and settlement payments made to financial institutions and financial participants in connection with a securities contract, commodity contract or forward contract. These include repurchase agreements, swaps and securities settlements. The court ruled that the transactions in question fit within the safe harbor because:

The court stressed the need for the safe harbor to be enforced as written and applied literally in the interest of market stability. The Bankruptcy Code's safe harbors for trading contracts, including section 546(e), were enacted so that financial markets would not be disrupted in the event of a major broker-dealer bankruptcy. The court therefore granted JPM's motion to dismiss on those counts seeking to avoid as preferences and constructive fraudulent transfers the transfers Lehman made to JPM during the months of August and September 2008. The court reasoned that the transactions in question were systemically significant transactions between sophisticated financial parties at a time of financial distress in the markets, which is the exact setting for which the safe harbors were intended.

The court also dismissed the counts seeking to avoid Lehman's "obligations" under its guarantees, even though that term does not appear in section 546(e) of the Bankruptcy Code, because the obligations in question were connected to the transfers that were protected by the safe harbor language of section 546(e).

The remaining counts relating to intentional fraud survived the motion to dismiss. The court reasoned that while the safe harbors of section 546(e) exist to protect the capital markets, intentional fraud is not protected by the safe harbor.

The court's decision indicates that the safe harbor in section 546(e) of the Bankruptcy Code will be upheld even if it appears that one party may have taken advantage of another. The public policy rationale behind the safe harbor requires this in order to prevent the financial markets from collapsing if a major bank fails. However, the decision also indicates that debtors may be able to sidestep the safe harbor if they can prove that prepetition transfers were made fraudulently.

The case emphasizes that banks that function in multiple trading counterparty and lending capacities to a distressed entity are granted wide latitude under the Bankruptcy Code in providing prepetition credit in an attempt to preserve the entity as a going concern. Conversely, distressed counterparties and borrowers should be aware that bankruptcy courts are not likely to set aside the Bankruptcy Code's safe harbors to permit recovery of enumerated prepetition transfers and that collateral posted during a run-up to bankruptcy may not be recovered. Entities engaged in trading and borrowing may also want to consider diversifying their counterparty and lender base so they are not forced to rely on and acquiesce to the demands of one creditor or counterparty in times of distress.