Fourteen months after oral argument, the Second Circuit affirmed the lower courts by holding in a per curiam opinion that the safe harbor exception to the automatic stay in Section 560 permits enforcement of a so-called flip clause in a swap agreement.

The opinion is notable because it is arguably contrary to the Supreme Court’s more narrow construction of other safe harbor provisions in the Bankruptcy Code. See Merit Management Group LP v. FTI Consulting Inc., 138 S. Ct. 883 (Feb. 27, 2018).

The decision was costly for creditors of Lehman Brothers Holdings Inc. and its subsidiaries, who will lose perhaps $1 billion from the inability to enforce flip clauses. Had the flip clauses been unenforceable as ipso facto clauses, the proceeds from the liquidation of swap agreements would have gone first to Lehman. But the bankruptcy of Lehman was a default invoking the flip clauses, which first directed proceeds from the liquidation of the swaps to noteholders.

After paying noteholders, nothing was left for Lehman or its creditors.

The Lehman Flip Clauses

Lehman and its subsidiaries had thousands of swaps in their portfolios when they began filing for chapter 11 protection in September 2008. Before bankruptcy, Lehman was “in the money” and stood to recover from the termination of many of the swaps.

The flip clauses provided that the collateral securing the swaps would go first to Lehman as the swap counterparty in an ordinary maturity or termination.

If Lehman were to file bankruptcy and thus cause an event of default, the swap counterparty could terminate the swap prematurely. Since Lehman was the defaulting party, the flip clause directed the collateral proceeds first to noteholders, not to Lehman. Since the noteholders were never paid in full, Lehman got nothing when the flip clauses were invoked, even though Lehman would have been in the money had there been an ordinary maturity.

The Lawsuit in Bankruptcy Court

Lehman sued 250 defendants in bankruptcy court in 2010, contending that the flip clauses violated the anti-ipso facto provisions in Sections 365(e)(1), 541(c)(1)(B) and 363(l) of the Bankruptcy Code. Lehman argued that the flip clauses were invalid because those subsections provide that contractual provisions are unenforceable if they become effective on insolvency or bankruptcy.

Five years into the adversary proceedings, the defendants filed motions to dismiss. Bankruptcy Judge Shelley C. Chapman granted the motions in June 2016, prompting Lehman to appeal. District Judge Lorna G. Schofield affirmed in March 2018. To read ABI’s discussions of the opinions, click here and here.

Affirmance in the Second Circuit

Lehman appealed, and the Second Circuit heard oral argument in June 2019. The 26-page affirmance was handed down in a per curiam opinion on August 11. The panel consisted of Circuit Judges Dennis Jacobs, Susan L. Carney and Joseph F. Bianco.

The opinion began by reciting how the “Bankruptcy Code generally bars enforcement of ‘ipso facto clauses,’ which trigger or modify payment obligations when a party seeks relief in bankruptcy.” The panel cited the lower courts for holding that “section 560 of the Bankruptcy Code . . . , which creates a safe harbor for the liquidation of swap agreements, allowed the distribution of proceeds according to the [flip clauses,] whether or not those provisions are properly characterized as ipso facto clauses.”

The circuit panel agreed.

Section 560 provides that the “exercise of any contractual right of any swap participant . . . to cause the liquidation, termination, or acceleration of one or more swap agreements because of a condition of the kind specified in section 365(e)(1) [an anti-ipso facto provision] of this title . . . shall not be stayed, avoided, or otherwise limited by operation of any provision of this title . . . .”

For the panel, the primary question was whether the distribution of proceeds from liquidation of a swap pursuant to a flip clause “constitutes the ‘liquidation’ of a swap agreement under section 560.”

The panel held that “that the term ‘liquidation,’ as used in section 560, must include the disbursement of proceeds from the liquidated Collateral.” The panel said that reading “liquidation” in Section 560 “to include distribution of the Collateral furthers the statutory purpose of protecting swap participants from the risks of a counterparty’s bankruptcy filing by permitting parties to quickly unwind the swap.”

The panel said, “we reject [Lehman’s] suggestion that Merit Management, a Supreme Court decision rendered after the Bankruptcy Court issued its ruling, invalidates the reasoning of either the Bankruptcy Court or the District Court. Merit Management analyzed a different safe harbor provision, 11 U.S.C. § 546(e).”

Affirming the lower courts, the panel held that “the term ‘liquidation,’ as used in section 560, is in our view broad enough to include the subordination of [Lehman’s] payment priority and distribution according to the amended waterfall of payment priorities.”

Because the panel held that the flip clauses were enforceable under the safe harbor in Section 560, the circuit court did not decide whether the flip clauses in fact are ipso facto clauses.

Observations

The Second Circuit in recent years has been protective of the interests of financial institutions. Its decision on the safe harbor in Section 546(e) was one of those overturned by Merit Management, a unanimous opinion written by Justice Sonia Sotomayor.

Merit Management significantly narrowed application of the safe harbor in Section 546(e) by holding that it only immunizes transfers where the ultimate transferor or transferee was a bank, broker or “financial participant.” In other words, including a bank in the chain of payments to the ultimate transferee does not invoke the safe harbor. The bank or financial institution must have skin in the game before the safe harbor in Section 546(e) puts a fraudulent transfer beyond the reach of a bankruptcy trustee. To read ABI’s report on Merit Management, click here.

Unanimously, Merit Management rejected the broad reading given by five circuits to the Section 546(e) safe harbor. Justice Sotomayor focused in significant part on “the plain language of the safe harbor.” Id. at 897.

If there is a flaw in the Second Circuit’s analysis, it’s in the interpretation of the word “liquidation” in Section 560. The appeals court understands the word to mean both the liquidation of collateral and the distribution of proceeds.

Respectfully, liquidation of assets and distribution are different concepts dealt with in different provisions of the Bankruptcy Code. Arguably, the appeals court departed from the language of the statute by equating the two terms.

Liquidation of swap collateral is clearly permitted by Section 560, but distribution of proceeds to noteholders in excess of their economic rights arguably is not required to protect the swap parties or markets. To protect credit markets, did Congress intend for noteholders to receive a windfall at the expense of a debtor and its creditors?