Despite the anti-ipso facto clause in the Bankruptcy Code, a properly drafted flip clause can be enforceable when terminating a swap agreement even after bankruptcy, according to an opinion by Bankruptcy Judge Shelley C. Chapman, who disagrees with former Bankruptcy Judge James M. Peck from whom she inherited the Lehman Brothers bankruptcy.

Even if there were a violation of the ipso facto clause, Judge Chapman ruled in her 55-page opinion on June 28 that a flip clause is enforceable under the exception to the automatic stay in Section 560 of the Bankruptcy Code, again disagreeing with decisions Judge Peck handed down before he retired from the bench in 2014.

After former Judge Peck’s first decision on the issue in 2010, it looked as though flip clauses were unenforceable in bankruptcy. Resulting in part from intervening Second Circuit authorities, the tables turned 180 degrees, making flip clauses now generally valid, assuming Judge Chapman’s analysis holds up on appeal.

Lehman and Flip Clauses

On filing for chapter 11 protection in September 2008, Lehman Brothers Holdings Inc. and its subsidiaries had thousands of swaps in their portfolios, some including so-called flip clauses. The flip provisions came into play when Lehman was “in the money” at the outset of bankruptcy and stood to recover from termination of the swaps.

Without going into detail about the alternative ways in which flip clauses were drafted, suffice it to say that the provisions provided that collateral ordinarily would go first to Lehman subsidiary Lehman Brothers Special Financing Inc. (known as LBSF) as the swap counterparty in an ordinary maturity or termination. 

On the other hand, if the Lehman parent or LBSF were to file bankruptcy, thus creating an event of default, the swap counterparty could terminate the swap prematurely. In those situations where Lehman or LBSF was the defaulting party, the flip clause would kick in and send the collateral proceeds first to noteholders. Since noteholders were never paid in full, LBSF got nothing when the flip clauses were invoked.

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

In different adversary proceedings involving different counterparties, Judge Peck wrote decisions in 2010 and 2011 where he agreed with Lehman and concluded that flip clauses violated the anti-ipso facto statutes. He also decided that § 560 did not apply. Neither of those decisions went up on appeal, and no other court in the meantime has pronounced on the validity of flip clauses in bankruptcy.

When Judge Peck left the bench, Judge Chapman took over the Lehman bankruptcy, including the adversary proceeding that gave rise to her decision in late June.

Judge Chapman’s Rationale

The defendants filed motions to dismiss, which Judge Chapman granted except for a pair of transactions with different facts where the defendants had not filed Rule 12(b)(6) motions. Judge Chapman disagreed with Judge Peck because she interpreted the Bankruptcy Code differently.

Among the defendants, there were important factual differences, allowing Judge Chapman more easily to dismiss as to some of them. The factual distinctions arose because the Lehman parent filed bankruptcy 18 days before LBSF. In all the transactions, LBSF was the swap party, and the Lehman parent was the guarantor of LBSF’s obligations. The first bankruptcy filing by the Lehman parent was a default giving the right to terminate the swaps with LBSF.

Some of the defendants terminated the swaps after the parent’s bankruptcy but before LBSF’s, and in others, the termination did not occur until after LBSF’s own chapter 11 filing. For Judge Peck, timing was important. In his 2010 decision, a termination after LBSF’s bankruptcy made it easier for him to rule that invoking the flip clause violated anti-ipso facto law. In dicta, however, Judge Peck said the result would have been the same even for terminations that came before the LBSF bankruptcy.

Analyzing § 560, which permits termination of swaps, Judge Chapman said it did not matter whether termination was before or after LBSF’s bankruptcy.

Judge Chapman divided the cases into two groups. Depending on how the swaps were written, one set of cases, the majority, did not even involve flip clauses, she said.

In what she called Type I cases, the swaps were written so LBSF would get the collateral on termination. The Type I agreements contained flip provisions switching the priority in collateral distribution to the counterparties if Lehman were the defaulting party.

Type II agreements contained no flip clauses, Judge Chapman said. Instead of changing the priority of distribution, Type II swaps had two different distribution regimes, one when Lehman filed bankruptcy and the other when Lehman did not default.

According to Judge Chapman, Type II agreements had no flip clauses because there was no modification of Lehman’s rights, just the application of the appropriate distribution regime. Consequently, counterparties with Type II agreements could terminate swaps under § 560 without running afoul of anti-ipso facto provisions because there were no flip clauses in the first place. In other words, adroit drafting could result in a different result without changing the substance of the underlying agreements.

Even if Type II agreements were interpreted as having flip clauses, Judge Chapman next held that the flip clauses were enforceable under § 560 if termination took place before the LBSF bankruptcy, even if distribution of proceeds occurred after LBSF’s bankruptcy. She held that the language in §§ 365(e)(1), 541(c)(1)(B) and 363(l) only bars modifications of debtors’ rights for actions taking place after bankruptcy.

Debunking the ‘Single Event’ Theory

Judge Peck invalidated terminations and distributions that occurred before LBSF’s bankruptcy using what he called the “single event” theory. He focused, for instance, on the language in § 365(e)(1)(B) which bars modification of rights based on commencement of “a” bankruptcy case, not “the” bankruptcy of “the” debtor invoking the anti-ipso facto laws.

Judge Chapman disagreed. She said the statutory references to “the case” can refer “only to the case of the debtor who is a party to the relevant executory contract.”

Consequently, Judge Chapman declined to adopt the single event theory and exercised discretion not to follow Judge Peck’s decisions as law of the case.

Section 560 Validates Flip Clauses in Any Event

Even if he had been correct up to this point, Judge Chapman again disagreed with Judge Peck and still validated the flip clauses under § 560. She said that Judge Peck’s narrow interpretations of § 560 preceded decisions from the Second Circuit giving safe harbors “broad and literal interpretation.” Among the decisions she cited was Tribune, decided in March. To read ABI’s discussion of Tribune, click here.

Lehman argued that § 560 does not apply to flip clauses because that section pertains only to “liquidation, termination, or acceleration” of swap agreements. In Lehman’s view, altering the priority of distribution was neither liquidation, termination, nor acceleration.

Given how the Second Circuit believes that safe harbors must be interpreted broadly, Judge Chapman declined to give § 560 a narrow interpretation.

Where Do We Go Next?

With the amount of money involved, Lehman is unlikely to roll over and play dead following Judge Chapman’s decision. However, the time for appeal has not arrived because dismissal orders are yet to be entered.

If there is an appeal, Lehman can argue that Judge Chapman’s decision elevates form over substance by holding that adroit drafting can turn a flip clause into something else.

Even victory on that issue will not carry the day unless Lehman can turn the tide in the Second Circuit by convincing the appeals court to reverse course and narrowly construe a safe harbor.

Very possibly, Lehman’s fate is sealed in the Second Circuit. To succeed, Lehman may need another appeals court to create a conflict of circuits on the safe harbors, so the Supreme Court can take up the issue.