In a broadly worded opinion, District Judge Lorna G. Schonfield of Manhattan ruled that a so-called flip clause in a swap agreement is enforceable under the exception to the automatic stay in Section 560 of the Bankruptcy Code.
Judge Schonfield affirmed a June 2016 opinion by Bankruptcy Judge Shelley C. Chapman and in the process disagreed with former Bankruptcy Judge James M. Peck, who had held in a pair of opinions in 2010 and 2011 that a flip clause is an ipso facto clause that is not enforceable under Sections 365(e)(1), 541(c)(1)(B) and 363(l) of the Bankruptcy Code.
The Lehman Flip Clauses
Lehman Brothers Holdings Inc. and its subsidiaries had thousands of swaps in their portfolios when they began filing for chapter 11 protection in September 2008. Some included so-called flip clauses that came into play when Lehman was “in the money” at the outset of bankruptcy and stood to recover from termination of the swaps.
Briefly stated, the flip clauses provided that collateral securing the swaps 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.
If the Lehman parent or LBSF were to file bankruptcy and thus cause an event of default, the swap counterparty could terminate the swap prematurely. If the Lehman parent or LBSF were the defaulting party, the flip clause would kick in and direct the collateral proceeds first to noteholders, not to LBSF. Since the noteholders were never paid in full, LBSF got nothing when the flip clauses were invoked, even though LBSF would have been in the money were there are an ordinary maturity.
In 2010, Lehman sued 250 defendants in bankruptcy court, 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 contended that flip clauses were invalid because those subsections provide 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 Section 560 did not apply. Neither of those decisions went up on appeal.
When Judge Peck left the bench, Judge Chapman took over the Lehman bankruptcy, including litigation over the flip clauses. The defendants filed motions to dismiss. Judge Chapman granted the motions in her opinion in June 2016, prompting Lehman to appeal. To read ABI’s discussion of Judge Chapman’s opinion, click here.
Judge Schonfield’s Opinion
In her 16-page opinion on March 14, Judge Schonfield did not keep the reader in suspense. After laying out the facts and Judge Chapman’s decision, she went to the heart of the case and said that flip clauses “do not violate the Bankruptcy Code” because they are protected by the safe harbor in Section 560.
Section 560 provides that “any contractual right of a swap participant . . . to cause the liquidation, termination or acceleration [of a swap agreement] shall not be stayed, avoided, or otherwise limited by operation of any provision” in the Bankruptcy Code. Citing legislative history, Judge Schonfield said that the “purpose of Section 560 is to protect securities markets.”
The purpose of Section 560 in mind, Judge Schonfield said that “the most sensible literal reading of Section 560 applies to the distributions in this case.” Enforcing a flip clause, she said, is the “‘exercise of [a] contractual right . . . to cause the liquidation [or] termination’” of a swap.
Judge Schonfield rejected Lehman’s argument that “liquidation” as used in Section 560 only refers to the calculation of amounts owed, not to the actual distribution of funds.
Because the safe harbors in the Bankruptcy Code must be “interpreted based on their plain meaning,” Judge Schonfield said that Lehman’s argument was “nonsensical because it would nullify any protection Section 560 provides to swap agreements.” The “mere calculation” of a swap, she said, would provide “no security to swap participants.”
Next, Lehman contended that the trustees who held the collateral were the only parties entitled to enforce the flip clauses. Since the trustees were not swap participants, according to Lehman, their actions were not protected by the Section 560 safe harbor.
Although she found no authority on the topic, Judge Schonfield said that Lehman’s “argument is incorrect and contrary to the plain language of the statute.” Section 560, she said, “only requires the exercise ‘of’ a swap participant’s contractual right, but that right need not be exercised ‘by’ the swap participant.” Therefore, when the trustees terminated the swaps, she said “they exercised the rights ‘of’” the swap participants.
Lehman also made claims under state law for unjust enrichment, constructive trust, money had and received, replevin and breach of contract. Those claims were properly dismissed, Judge Schonfield said, because the distributions were not improper given that the flip clauses “were not unenforceable ipso facto clauses.”
Judge Schonfield also upheld dismissal of Lehman’s fraudulent transfer claims based on the notion that the swap participants did not give fair consideration. Since the payments “indisputably” were repayments of a debt owning to the swap participants, they gave fair consideration, thus barring any fraudulent transfer claims.
Judge Schonfield specifically declined to follow Judge Peck’s decisions from 2010 and 2011, saying that they were not binding authority.