On June 28, 2016, the US Bankruptcy Court for the Southern District of New York (Lehman court) issued a decision in Lehman Brothers Special Financing Inc. (LBSF) v. Bank of America National Association, et al., Case No. 10-3547, in which the court considered for the third time the enforceability in US bankruptcy proceedings of "flip clauses" in ABS swap transaction documents ( (Bankr. S.D.N.Y. June 28, 2016)).

The ruling diverged somewhat from the court's prior flip-clause holdings in the BNY/Perpetual and Ballyrock cases, and provides some drafting guidance.

LBSF brought the action against trustees, noteholders, and note issuers in 44 different securitization transactions – primarily synthetic CDOs – for which LBSF was swap provider, seeking a declaratory judgment and approximately $1 billion distributed to the defendants following the commencement of the Lehman Brothers Chapter 11 bankruptcy proceedings in September 2008.

In a synthetic CDO, credit protection payments from the swap provider (as protection buyer) to the issuer (as credit protection seller) under credit default swaps (CDS) in the asset pool create the cash flows for the CDO to pay principal and interest to the CDO noteholders, and make payments to other transaction parties. Therefore, in a synthetic securitization, the swap provider plays a much more important role than in a traditional securitization in which a revenue stream is generated by a pool of assets such as mortgages (see Practice Note, Securitization: US Transaction Parties and Documents: The Swap Provider). Default of the swap provider for any length of time in a synthetic ABS transaction is usually fatal to the transaction's cash flows and solvency (see Practice Note, Securitization: US Overview: Securitization Distributions and Payments: Cash Flows in a Standard US Securitization).

The CDS included in these CDO transactions were documented under a 1992 ISDA Master Agreement (ISDA Master) between the special purpose issuer in each of the CDOs and LBSF. The ISDA Master permits termination of the transaction and liquidation of margin collateral posted in connection with the swap with proper notice upon a counterparty default (known as early termination – for details, see Practice Note, The ISDA Master Agreement: Early Termination).

The termination and liquidation provisions of the ISDA Master would normally be unenforceable ipso facto clauses in a US bankruptcy proceeding, but they are safe harbored under section 560 of the Bankruptcy Code which protects the right of a nondefaulting party to liquidate, terminate, or accelerate a swap contract based on a counterparty bankruptcy default (see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist).

This and other safe harbors for financial contracts were legislated in order to avoid disruption of the financial markets that would otherwise be caused by defaults under these contracts (though the safe harbors are the subject of some controversy, as they favor certain transaction counterparties over other creditors).

Lehman Brothers Holdings Inc. (LBHI) filed its bankruptcy petition on September 15, 2008. Since LBHI was both a guarantor of LBSF's payment obligations under the CDS transactions on which the CDO cash flows were based, and a credit support provider to LBSF, LBHI's bankruptcy triggered an Event of Default under the ISDA Masters governing the CDS transactions, with LBSF as the defaulting party. LBSF filed its own bankruptcy petition on October 3, 2008, 18 days after LBHI.

Upon early termination under Section 6(e) of the ISDA Master, the party that is in the money on the termination date under the CDS transaction is entitled to a termination payment based on a reasonable good-faith calculation of its anticipated losses under the transaction (see Practice Note, The ISDA Master Agreement: Early Termination: The Section 6(e) Early Termination Payment).

LBSF was in the money on certain of these transactions and was therefore entitled to a termination payment, even thought it was the defaulting party, as the parties had elected Second Method under the 1992 Master (for details, see Practice Note, Understanding the ISDA Master Agreement and Schedule: Section 14: Definitions: Settlement Amount (1992 Master)).

As swap provider, LBSF was to be paid in each transaction in accordance with the priority of payments or waterfall provision in the CDO indentures. Similar provisions are included in transaction documents for all ABS (for details, see Practice Note, Securitization: US Overview: Securitization Distribution and Payments: Distribution of Funds: The Waterfall).

However, when LBSF defaulted under the swap agreements, the flip clause was activated and LBSF's priority in the CDO's payment waterfall fell. (The flip clause is designed to subordinate swap payments when the swap provider defaults under the swap.)

Upon liquidation of the CDOs, once noteholders and other parties were paid the proceeds of the liquidated collateral pool, nothing was left to pay LBSF its early termination payment under the terminated swaps for which it was in the money.

LBSF's claim in this action was twofold:

As in the prior flip clause actions, BNY/Perpetual and Ballyrock, the Lehman court was asked to rule on whether the flip clauses were ipso facto clauses, unenforceable in bankruptcy. The rulings in the prior cases were in the affirmative – the flip clauses were ipso facto provisions and not enforceable in a US bankruptcy proceeding (see Practice Note: Key US Cases Affecting Securitization Transaction Documentation: The Flip Clause Cases: Perpetual (Belmont Park/BNY) and Ballyrock). (It is worth noting that a UK court reached the opposite result and found the flip cause enforceable in the corollary BNY/Perpetual UK proceeding – see Legal Update, UK Supreme Court Confirms Enforceability of Flip Clauses in Belmont Park (Perpetual) Decision.)

Here, however, the Lehman court granted defendants' motion to dismiss LBSF's claims against the 250 defendants, dismissing LBSF's claims seeking to recover funds distributed to the defendants following the Lehman Brothers Chapter 11 bankruptcy proceedings.

The defendants argued that the CDO waterfall provisions did not modify LBSF's rights after the filing of its bankruptcy petition and, further, even if the flip clauses were in fact unenforceable ipso facto provisions, distributions made to the defendants were still protected by the safe harbor provision of section 560 of the Bankruptcy Code.

Since the LBHI bankruptcy petition preceded the LBSF filing, the Lehman court identified three phases of liquidation of the CDO collateral and subsequent payment distributions:

The timing of the liquidations played an important role in the court's analysis.

The Lehman court identified two materially distinct waterfall provisions in the CDO transaction documents:

The Lehman court looked separately at each type of transaction. For Type 1 transactions (all of which were Post-Post transactions), the Lehman court found that the priority payment provisions were indeed unenforceable ipso facto clauses. However, the Lehman court adopted a broad reading of the section 560 safe harbor and found that the distributions were nevertheless protected by the safe harbor protections of section 560 of the Bankruptcy Code from the clawback remedy LBSF sought. The court's decision is consistent with other Second Circuit and district court decisions post BNY/Perpetual and Ballyrock that similarly found that a broad reading of safe harbor provisions is in keeping with congressional intent.

The Lehman court found that the Type 2 priority payment provisions were not unenforceable ipso facto provisions because LBSF never held a right to payment priority at the outset of the transaction. Instead, the "toggle" provision dictated payment priority rights, meaning that LBSF would only have payment priority rights if the necessary conditions triggered it, which they did not, since it was in default under the swaps at the time the payments were made under the CDO waterfalls.

With regard to the Type 1 transactions, LBSF argued that the enforcement of the waterfall payment priority provisions did not constitute a "liquidation" or "termination" of a swap agreement and thus section 560 was not applicable. However, the Lehman court did not find this argument persuasive.

Section 560 protects the contractual right of a swap or financial participant to "liquidat[e], terminat[e], or accelerat[e] a swap agreement pursuant to the occurrence of" bankruptcy or insolvency. Relying on the plain-language definition, the Lehman court sided with the defendants that the term "liquidate," as used in section 560, included both the liquidation of the collateral as well as its distribution.

Thus, section 560 protected both the enforcement of the waterfall payment provisions as well as the distribution of funds pursuant to it.

The court noted further that the enforcement of the waterfall payment priority provisions was indeed a right held by the issuers, who met the definition of "swap participants" as required in section 560 and defined in section 101(B)(53C). This in tandem with the Lehman court’s broad reading of the safe harbor provision protected the payment distributions made in Type 1 transactions to the defendants from the claw back remedy LBSF was seeking.

The Lehman courts in BNY/Perpetual and Ballyrock found that the LBHI and LBSF bankruptcies were "singular events" such that LBSF benefitted from protection of the Bankruptcy Code's safe harbors from the moment LBHI filed its petition even though LBSF's bankruptcy petition was not filed until 18 days later. Under this "singular event theory," a fully integrated enterprise such as LBSF could benefit from the ipso facto protections in the bankruptcy filing of its parent, LBHI.

This court, however, declined to adopt the "singular event theory" of BNY and Ballyrock. In the court’s discussion of BNY/Perpetual, it noted the need to return to uniformly and readily applicable legal principles in the Bankruptcy Code as opposed to unique interpretations, and that the plain language of section 365(e)(1) of the Bankruptcy Code dictated that the Lehman court not follow the "singular event theory" of BNY/Perpetual.

Although this decision will likely be appealed by LBSF, for the time being it adds clarity to flip clause interpretation. As noted, flip clauses are found in the transaction documents for most ABS.

With this case as guidance, swap providers may look to take inventory of their ABS flip clauses. Firms will no doubt be called upon to diligence legacy ABS documents of all kinds to determine whether they most closely resemble Lehman Type 1 or Lehman Type 2 language.

Parties may also be advised by the ruling in the drafting of their indentures and pooling and servicing agreements. Issuer's counsel is likely to prefer Type 2 "toggle" payment priority provisions so as to avoid being captured by the conditional-priority (ipso facto) prohibition of section 365(b)(2) of the Bankruptcy Code. While counsel to the swap provider is more likely to prefer traditional Type 1 language.