United States: Flipping On Flip Provisions: Lehman Bankruptcy Court Rules Flip Provisions Enforceable In Bankruptcy

A recent decision from Judge Chapman in the Lehman Brothers bankruptcy cases departs from precedent in the same case – although issued by a different judge – in determining that so-called "flip" provisions in swap agreements are protected by the Bankruptcy Code's safe harbor provisions for swap agreement transactions. See Lehman Brothers Special Financing, Inc. v. Bank of America N.A. (In re Lehman Brothers Holdings, Inc.), Case No. 10-03547 (Bankr. S.D.N.Y. June 28, 2016). The ruling is noteworthy not only because it offers significant guidance to parties in the financial markets in crafting contractual language to comply with the Bankruptcy Code, but also because it departs from the BNY1 and Ballyrock2 opinions issued in 2010 and 2011 in the Lehman cases. In those decisions, Judge Peck found similar flip provisions to be unenforceable ipso facto clauses.

Lehman Brothers Special Financing Inc. (LBSF) was a party to over 40 credit default swaps with various issuers in connection with various CDOs. When LBSF's parent, Lehman Brothers Holdings, Inc. (LBHI), filed bankruptcy on September 15, 2008, the issuers under the various swap agreements declared defaults by LBSF and liquidated the underlying collateral. Because LBSF was the defaulting party, proceeds of the collateral were paid to parties other than LBSF. Had LBSF not been the defaulting party, however, it would have received the proceeds. Thus, LBSF's payment priority was "flipped" by its default under the agreements caused by LBHI's bankruptcy.

In general, contractual provisions that negatively impact the rights of a debtor in bankruptcy simply because the debtor filed bankruptcy—so-called ipso facto clauses—are not enforceable against the debtor. Such provisions can, however, be enforced against the debtor if the right to exercise the provision falls under certain safe harbors in the Bankruptcy Code. The question in Lehman Brothers Special Financing, Inc. v. Bank of America N.A. was whether the flip provisions at issue were ipso facto clauses under the Bankruptcy Code, and, if so, were they nonetheless protected by the safe harbors contained in 11 U.S.C. §560?

There were two sets of flip provisions at issue in the case. The first set gave LBSF payment priority at the outset of the contract, but flipped LBSF to a subordinated position upon its default. Consistent with Judge Peck's rulings in BNY and Ballyrock, Judge Chapman found that these agreements did in fact alter LBSF's priority rights and were, therefore, ipso facto provisions. The second set of provisions were found to be silent as to payment priority amongst the parties absent a default. Instead, priority was not established until an event of default occurred. The court found that contracts in this second category did not alter any rights of LBSF because LBSF never held a priority position to be flipped. Thus, such contracts did not contain ipso facto clauses and were enforceable.

Further, many of the swap agreements at issue were terminated prior to LBSF's bankruptcy petition, which was not filed until October 3, 2008, three weeks after LBHI filed its case. The court found that because such terminations occurred prior to LBSF's bankruptcy petition, the anti-ipso facto protections of the Bankruptcy Code were not applicable. In so ruling, the court rejected the "singular event" theory developed by Judge Peck in BNY. There, Judge Peck found that the unique circumstances of LBHI's bankruptcy filing triggered the anti-ipso facto protections of the Bankruptcy Code with respect to LBSF contracts, even though LBSF had not yet filed bankruptcy. Judge Chapman declined to follow the "singular event" theory and found that any modification of LBSF's rights prior to LBSF's petition cannot be a basis for violation of anti-ipso facto provisions.

Finally, Judge Chapman found that enforcement of all of the flip provisions at issue were protected by Bankruptcy Code section 560, which protects the "exercise of any contractual right of any swap participant or financial participant to cause the liquidation, termination, or acceleration of one or more swap agreements," notwithstanding that such right is an ipso facto provision. This result is contrary to the BNY and Ballyrock decisions, in which Judge Peck found that similar flip provisions were not protected by section 560. In distinguishing BNY and Ballyrock, Judge Chapman initially noted that since those cases were decided, the Second Circuit has repeatedly noted that the safe harbor provisions of the Bankruptcy Code require a "broad and literal interpretation," rather than the more narrow interpretation of those provisions contained in BNY and Ballyrock. Judge Chapman next distinguished the BNY opinion by noting that Judge Peck "relied in no small measure on a ruling that the priority provisions at issue in that case 'did not comprise part of the swap agreement.'" Rather, Judge Peck found in BNY that a "review of the components of each Swap Agreement . . . reveals that there is no reference at all" to the indenture or other transaction documents containing the actual flip provisions at issue. By contrast, Judge Chapman found that the flip provisions at issue here were "either explicitly set forth in the schedules to the ISDA Master Agreements" or incorporated into those agreements by specific reference to other transaction documents.

The Ballyrock decision, however, did not rely on a ruling that the flip provisions were not included in the swap agreements. In Ballyrock, Judge Peck found that the flip provisions "deprived LBSF of pre-existing distributions rights" and were not entitled to protection under safe harbor "provisions that, by their express terms, are limited exclusively to preserving the right to liquidated, terminate, and accelerate." Judge Chapman, on the other hand, found that a plain reading of section 560 and the word "liquidation" leads to the conclusion that "section 560 protects the enforcement of the Priority Provisions and the distribution of the proceeds of the sale of the Collateral as part of the exercise of the right to liquidate the Swaps." Thus, the decision appears to be in conflict with Ballyrock regarding the scope of the term "liquidation" as used under section 560.

Judge Chapman's decision in Lehman Brothers Special Financing, Inc. v. Bank of America N.A. is an important decision in the ongoing development of safe harbor case law and continues the trend of interpreting the Bankruptcy Code's safe harbor provisions broadly and literally. The case also offers significant guidance to financial market participants in drafting what might otherwise be construed to be unenforceable ipso facto provisions to ensure their compliance with the various safe harbors contained in the Bankruptcy Code.


1 Lehman Bros. Special Fin. Inc. v. BNY Corp. Trustee Servs. Ltd., 422 B.R. 407 (Bankr. S.D.N.Y. 2010) (JMP) ("BNY").

2 Lehman Bros. Special Fin. Inc. v. Ballyrock ABS CDO 2007-1 Ltd (In re Lehman Bros. Holdings, Inc. ), 452 B.R. 31 (Bankr. S.D.N.Y. 2011) (JMP) ("Ballyrock").

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