A recent U.S. bankruptcy case has challenged the enforceability of a common structured finance provision and exposed many highly rated transactions to the risk of downgrade and default.
In many structured finance transactions, investors acquire notes of a special purpose issuer secured by or linked to specific assets or collateral. Often the issuer will enter into a swap to hedge interest rate or currency risks or to assume additional credit risk and generate additional returns. In most transactions, amounts payable to a swap counterparty are factored into cash flows and take priority over amounts payable to investors, except for unexpected swap termination payments where the termination was caused by a default or the bankruptcy of the swap counterparty. Without this subordination mechanism, also known as a "flip clause":
- any swap termination payment would remain senior to investors; and
- if the swap was "out of the money" and the termination payment sufficiently material, then investors might be exposed to losses they would not have otherwise been exposed to had the swap not terminated at that time.
Accordingly the "flip clause" is needed in order to ensure that the investors' notes are not exposed to the bankruptcy risk of the swap counterparty and can therefore carry a higher credit rating than the counterparty. These clauses are particularly important in situations where the market value of a swap changes dramatically in the course of a transaction and exposes the investors to unexpected market risk over and above expected credit losses.
This new decision is a significant departure from the expectations of parties to structured finance transactions and strikes a further blow to an industry already reeling from the effects of the credit crisis.
In Lehman Brothers Special Financing Inc. v. BNY Corp. Services Ltd., Case No. 08-13555, Adv. No. 09-01242 (Bankr. S.D.N.Y. Jan 25, 2010), Judge Peck of the Bankruptcy Court for the Southern District of New York held that a market standard "flip clause" in an English law trust deed that flipped the priority of payments upon the bankruptcy default of a swap counterparty (or its ultimate holding company) was unenforceable on the basis that it:
- violated the ipso facto and automatic stay provisions of the US Bankruptcy Code; and
- failed to constitute an enforceable subordination agreement.
Ipso Facto And Automatic Stay Violations
Under the US Bankruptcy Code, provisions in an executory contract that modify rights upon a bankruptcy are unenforceable as ipso facto clauses. Judge Peck found that the swap agreement was an executory contract as both parties had unperformed obligations, that the Chapter 11 cases of the swap counterparty and its affiliates should be treated as a singular event, that the swap counterparty had a property interest that was entitled to protection at the relevant date and that the flip clause modified that property interest due to bankruptcy. Accordingly, the flip clause violated the ipso facto provisions of the US Bankruptcy Code.
In addition, as the flip clause was not part of the swap agreement, it was not protected by the automatic stay provisions of the US Bankruptcy Code, which in any event do not safely harbour the alteration of rights but instead only safely harbour the termination, liquidation and acceleration of swap agreements.
Judge Peck also held that the flip clause did not constitute an enforceable subordination agreement because the subordination was not fixed but rather was shifting in nature.
Harmonization Of Conflicting Decisions?
Judge Peck noted that the very same flip clause had been held to be enforceable under English law.1 Nevertheless, he concluded that the English courts had not sufficiently considered the US issues in making such determination.
The conflicting decisions are to be the subject of a hearing in the United States in an attempt to reconcile them. As it stands, the trustee cannot make payments under the relevant notes without being in contempt of one of the decisions.
Implications For Structured Finance
Since there are not enough funds available to pay both the noteholders and the swap counterparty in this case, unless the decision is overturned, Lehman Brothers Special Financing will likely receive a windfall of billions of dollars from various structured finance transactions contrary to the terms of the transactions and the intentions of the parties. Investors in highly rated structured notes who had not intended to take Lehman risk will suffer massive losses, and creditors of Lehman who did agree to take Lehman bankruptcy risk will instead be repaid.
Of more general concern, the enforceability of certain market standard subordination provisions or flip clauses is now uncertain and the commercial expectations of structured finance market participants have been frustrated.
For rated structured finance transactions where the swap counterparty or its affiliates are subject to US bankruptcy legislation (irrespective of governing law), rating agencies will likely revisit existing ratings criteria and notes may be downgraded depending upon the type and size of the swap, the credit and bankruptcy risk of the counterparty, the tenor of the notes and whether the potential swap termination payments are likely to be material over the remaining weighted average life of the notes and whether the rating of the notes is greater than the rating of the swap counterparty.2
Where restructurings are possible and for new transactions, parties will likely modify flip clauses and subordination provisions to dissociate them from bankruptcy scenarios or where possible avoid direct contracts with swap counterparties that are subject to U.S. bankruptcy law altogether.
The case is expected to be appealed and rating agencies may await the outcome of any appeal before taking rating action.
1. Perpetual Trustee Co. Ltd. v. BNY Corp. Trustee Services Ltd.,  EWCA (Civ) 1160 (Eng.)
2. See for example Fitch Ratings' Press Release dated January 29, 2010 and Moody's Investors Service Structured Finance Research publication issued on February 1, 2010.
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