Perpetual Trustee Company Limited v. BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc. [2009] EWHC 1912 (Ch)

The High Court of England and Wales recently upheld the priority given to investors over the rights of Lehman Brothers as a swap counterparty in a credit-linked note structure. This means that, as a matter of English law, Lehman Brothers' default under the swap will cause it to rank behind the investors on the application of the collateral which secures the amounts owed to the investors and Lehman Brothers.

The decision is significant because the contractual provisions providing for noteholder priority that the court found to be valid under English law are commonly used in rated and other structured finance transactions. The decision is also a key factor in determining the value of the product known as "Lehman Minibonds" which were widely distributed in a number of jurisdictions (including Hong Kong).

The facts

Perpetual, together with other holders of notes to which similar contractual priority provisions apply, brought an action against BNY. BNY holds the collateral that secures the amounts owed to investors and Lehman Brothers. The action was designed to obtain orders from the Court requiring BNY to realise the collateral and distribute the proceeds to investors.

The investors bought credit-linked notes. The amounts payable to investors could decrease if credit events (including insolvency) occurred in respect of entities called reference entities. Lehman Brothers entered into a swap with the issuer of the notes. The swap funded what was due under the notes. The amounts owed by the issuer under the notes and the swap were secured by security granted over various types of collateral held on trust by BNY.

The key point

The trust deed provided the proceeds from the collateral should be applied first to amounts owed to Lehman Brothers under the swap and second to the amounts owed to investors under the notes unless Lehman Brothers was in default under the swap. If Lehman Brothers defaulted, it would instead rank behind the investors on the distribution of collateral proceeds.

Lehman Brothers was in default under the swap because it failed to pay amounts due. It was also insolvent.

The issue for the court was whether the change in the order of priority triggered by Lehman Brothers' default under the swap was valid under English law.

The trust deed was governed by English law.

The US angle

Lehman Brothers intervened in the Perpetual action. Lehman Brothers complained to the US Bankruptcy Court that the provisions on which Perpetual relied breach several provisions of the US Bankruptcy Code (mainly that the change in priority deprives Lehman Brothers of an asset (being the priority of amounts owed under the swap) because of its bankruptcy). Lehman Brothers argued the application of the basic English law proposition that the property of a person cannot be taken away on insolvency. Lehman Brothers applied for the Perpetual action to be stayed pending the resolution of the US proceedings.

The decision

The Chancellor of the High Court held that the provisions in the trust deed that provided for noteholders to have priority over the swap counterparty in circumstances where the swap counterparty was in default were not contrary to public policy because:

  • it was important to consider the structure of the transaction as a whole (and not the noteholder priority provisions in isolation). The Court considered that the dispute was brought in respect of the collateral which was purchased with the proceeds invested by noteholders: the collateral was "in no sense derived directly or indirectly from... the swap counterparty";
  • as a general principle, commercial transactions should not be interpreted so as to invalidate them, particularly where the consequence would be to cast doubt on other, long-standing commercial transactions;
  • the intention of the parties was that the swap counterparty's right to receive proceeds of the collateral in priority to noteholders was, from the outset, "limited and conditional" upon the swap counterparty continuing to perform under the credit default swap. The swap counterparty's priority "never extended to a time after the event of default in respect of which it was the defaulting party had occurred".

That is, the swap counterparty was never entitled to the right to be paid first if it was in default. As a result, the right could not be taken from it on its insolvency and, therefore, the priority given to noteholders did not offend public policy and was valid under English Law.

What happens next?

Leave to appeal the decision has been granted.

Lehman Brothers argued:

  • the High Court's decision should be stayed pending resolution of the proceedings before the US Bankruptcy Court (Lehman Brothers argued the decision of the High Court should take into account any decision yet to be given on the same point by the US Bankruptcy Court), and
  • the High Court should not attempt to inhibit the US Bankruptcy Court from ruling on the US bankruptcy issues nor should it make a decision which would prevent the US Bankruptcy Court exercising its right to use international law to ask the English courts to assist on the implementation of a contrary US decision.

These arguments are pivotal because they go to the question whether English courts will have regard to the decision of the US Bankruptcy Court.

The Court decided that, having adjourned the proceedings (until at least 1 October 2009) to enable the parties to resolve the extent to which BNY would be indemnified from the proceeds of the realisation of the collateral, it was not appropriate to determine the questions raised by the multi-jurisdictional insolvency of Lehman Brothers nor necessary to grant the temporary stay sought by Lehman Brothers. The Chancellor considered that the length of the adjournment would provide sufficient time for the US Bankruptcy Court to determine Lehman Brothers' complaint (in light of the decision of the High Court that the noteholder priority provisions of the trust deed were valid under English law) and for the foreign insolvency officials to decide upon any further action they wish to take in connection with the collateral in the context of Lehman Brothers' insolvency.


The case clearly decides that, as a matter of English law, the noteholder priority provisions work as drafted.

It remains to be seen whether an appeal will be successful and the extent to which an English court will have regard to, or will be required to co-operate with, any decision of the US Bankruptcy Court.

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.