United States: Enforceability Of Subordination Provisions In Synthetic CDOs – Lehman Revisited

On June 28, 2016, Judge Chapman of the U.S. Bankruptcy Court for the Southern District of New York ruled in Lehman Brothers Special Financing Inc. v. Bank of America National Association, et al. (Adv. Proc. No. 10-03547 (Bankr. S.D.N.Y. June 28, 2016)) (referred to herein as "BAML") that the termination and liquidation of swaps linked to synthetic collateralized debt obligations (each a "CDO") and the distribution of the approximately $1 billion of proceeds of the sale of collateral under the indentures and trust agreements (collectively referred to as "indentures") for the CDOs were protected under the Bankruptcy Code safe harbors. The opinion relied on the fact that the so-called waterfall provisions in those CDOs, which list the parties that will be entitled to payments from the securitization vehicle and the priority in which they will be paid upon a distribution of proceeds from the liquidation of such collateral after termination of the swaps ("Priority Provisions") were either explicitly set forth in the schedules to the ISDA Master Agreements or were incorporated into such schedules from the CDO indentures. The ruling provides investment funds with much-needed certainty with respect to the enforceability of similar Priority Provisions in CDOs and other structured products containing swaps that would prevent noteholders from being subordinated to the swap counterparty in the event of a swap counterparty's bankruptcy. While enforceability of those Priority Provisions was previously put into question by other cases in the Lehman Brothers Chapter 11 bankruptcy, this decision aligns much more closely to the market's expectations.

2010 U.S. Bankruptcy Court Decision in LBSF v. BNY

Previously, on January 25, 2010, Judge Peck of the U.S. Bankruptcy Court for the Southern District of New York held in Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services. Ltd. (422 B.R. 407, 420 (Bankr. S.D.N.Y. 2010)) (referred to herein as "BNY") that a standard clause in CDO indentures designed to subordinate or "flip" the priority of a swap counterparty's claim upon the swap counterparty's default may not be enforceable where the default is triggered by the bankruptcy filing of either the swap counterparty or its guarantor. In the CDO at issue in BNY, the amounts payable to noteholders would be subordinated to amounts payable to Lehman Brothers Special Financing Inc. ("LBSF") as swap counterparty ("Swap Counterparty Priority"), unless an event of default occurred with respect to LBSF as swap counterparty (including a default of its guarantor Lehman Brothers Holdings, Inc. ("LBHI")). In the case of such default, the Priority Provisions would flip and LBSF as swap counterparty would become subordinated to the noteholders ("Noteholder Priority").

LBHI filed its Chapter 11 petition on September 15, 2008. Because LBHI was a "credit support provider" (i.e., a guarantor) of LBSF, this filing constituted an event of default with respect to LBSF under the swap agreement. On October 3, 2008, LBSF filed its Chapter 11 petition, which also constituted an event of default under the swap agreement. On December 1, 2008, the securitization vehicle sent a notice to LBSF terminating the swap agreement, citing LBSF's bankruptcy filing as the relevant event of default. The securitization vehicle then terminated the swaps and liquidated the collateral for distribution in accordance with the Noteholder Priority.

In BNY, the bankruptcy court held that the Priority Provisions at issue constituted unenforceable ipso facto clauses under sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code, which invalidate defaults conditioned upon the commencement of a case under the Bankruptcy Code, and that a safe harbor provision in section 560 of the Bankruptcy Code did not protect the distributions made pursuant to the Priority Provisions in the related CDO. The Priority Provisions were found to be ipso facto provisions in part because the termination of the swaps (including the delivery of notice of termination) and the liquidation and distribution of the collateral occurred following LBSF's bankruptcy. Notwithstanding this fact, Judge Peck noted in dicta that even though LBSF's bankruptcy filing had not occurred at the time of a default under the CDO triggered by LBHI's bankruptcy filing, the flip provision was still an unenforceable ipso facto clause since the Chapter 11 cases of LBHI and LBSF were a "singular event for purposes of interpreting" the ipso facto language in sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code given that the Lehman affiliates formed an "integrated enterprise" (i.e., the holding would have applied notwithstanding the fact that the default did not necessarily result from LBSF as swap counterparty's own bankruptcy case).

Although the decision, together with a related English litigation, was appealed, final judgment was never reached as Judge Peck ultimately approved LBSF's motion for approval of a settlement among LBSF, BNY Corporate Trustee Services Limited, and others in connection with the particular note issuance program to which the CDO at issue was related.

BNY Revisited in LBSF v. BAML

In BAML, LBSF sought to recover approximately $1 billion of proceeds of the sale of the collateral under the indentures and trust agreements for 44 CDOs. Given the lack of uniformity of the provisions in the CDOs, and in a seeming attempt to diverge from the reasoning in BNY, the court grouped the Priority Provisions in the CDOs into two groups. The first group (referred to by the court as "Type 1" transactions) contained flip clauses similar to those found in the CDO at issue in BNY. In Type 1 transactions, LBSF's right to Swap Counterparty Priority pre-bankruptcy was characterized as being altered since the bankruptcy filing resulted in a flip to Noteholder Priority. The second group (referred to by the court as "Type 2" transactions) contained "toggle" clauses in which two possible waterfalls could become applicable upon early termination of the swaps. The main distinction, which is really more form over substance, is that in the Type 2 transactions having a toggle as between the priority of the noteholders and LBSF would not be determined under the Priority Provisions until the time at which an early termination notice was delivered and the circumstances surrounding early termination were determined. In that respect, under Type 2 transactions LBSF was not divested of any right to Swap Counterparty Priority upon its bankruptcy filing.

The court further grouped Type 1 and Type 2 transactions by the circumstances surrounding the timing of delivery of notice of early termination of the swaps and liquidation of the collateral for purposes of the court's holding and distinguishing the reasoning from BNY. The court referred to three subsets of circumstances: "pre-pre," "pre-post" and "post-post." In these groupings, the first "pre" or "post" represented whether the delivery of notice of early termination of the swaps occurred before or after the bankruptcy filing and the second "pre" or "post" represented whether the liquidation of the collateral and distribution of proceeds occurred before or after the bankruptcy filing. Judge Chapman noted that all Type 1 transactions were "post-post" transactions and the Type 2 transactions contained a mixture of "pre-pre" and "pre-post" transactions. For purposes of determining whether LBSF's rights were modified, the court found that only the first "pre" or "post" (i.e., the delivery of notice of early termination of the swaps) was potentially impactful to LBSF's rights.

With respect to Type 1 transactions (containing the flip clause Priority Provisions similar to those in BNY), consistent with Judge Peck's decision in BNY, Judge Chapman held that the Priority Provisions in Type 1 transactions were unenforceable ipso facto clauses. However, notwithstanding this finding, she held that section 560 of the Bankruptcy Code protects the termination of the swaps and liquidation and distribution of the collateral, distinguishing the CDOs at issue from the CDO in BNY by noting that the Priority Provisions in the CDOs at issue were either explicitly set forth in the schedules to the ISDA Master Agreements or were incorporated into such schedules from the indentures. In a footnote to the opinion, the court points to one particular ISDA Master for a representative provision: "all amounts, payable or expressed to be payable by [the Issuer] on, under or in respect of its obligations and liabilities under this Agreement and any Confirmation hereunder shall be recoverable ... subject in any case to the Priority of Payments set out in the Indenture." The court noted that the CDO in BNY contained no such provision.

With respect to Type 2 transactions, Judge Chapman held that the Priority Provisions in Type 2 transactions were not unenforceable ipso facto clauses because LBSF's rights following its bankruptcy were not modified. This was the case since the outcome of the Priority Provisions was not determined prior to the termination of the swaps and accordingly LBSF did not lose a right it otherwise had prior to its bankruptcy. The court further noted that even if the Priority Provisions in Type 2 transactions were found to be unenforceable ipso facto clauses, any modifications to LBSF's rights would have occurred prior to bankruptcy since they were all "pre-pre" or "pre-post" transactions, so the outcome would be the same as noted with respect to Type 1 transactions in that section 560 of the Bankruptcy Code would protect the termination of the swaps and liquidation and distribution of the collateral. In making this determination the court reasoned that the relevant petition date is the petition date for the swap counterparty (whose rights would potentially be modified) and not the guarantors, and that the "singular event" theory articulated in BNY should not apply.

Although LBSF has yet to appeal to the decision, that possibility certainly exists so the implications of the bankruptcy court's holding remain to be seen. Assuming the decision is upheld, takeaways for investment funds and their managers holding or considering investments in CDOs and other structured products having swaps are as follows: (1) Priority Provisions that "toggle" upon a swap counterparty's bankruptcy are favored over those that "flip," as there seem to be stronger arguments that toggle clauses are not unenforceable ipso facto clauses, even though both types of provisions could yield the same results; and (2) Priority Provisions either explicitly should be set forth in the schedules to the ISDA Master Agreements or be incorporated into such schedules from the CDO indentures in order to ensure that noteholders will not be subordinated to the swap counterparty upon a swap counterparty's bankruptcy. In addition, funds and their managers should be able to take some comfort that, where a swap counterparty receives one or more guarantees for its swap obligations, Priority Provisions should not be invalidated by virtue of a timing issue arising between a swap counterparty's bankruptcy and a guarantor's bankruptcy owing to the "integration" of the swap counterparty and the guarantor.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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