The Lehman Brothers chapter 11 case will set many historic records and provide much “new” law before it winds down. One recent decision has caused an international uproar and great consternation in the structured-finance markets because of its holding interpreting parts of a structured-finance transaction that is diametrically opposite to that of English courts interpreting the same provisions between the same parties. It is not just the international jet-setters of structured finance who are finding out that Lehman Brothers is an educational experience, it is also enlightening for more mundane practitioners.
In Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Limited (In re Lehman Brothers Holdings Inc.), 422 B.R. 407 (Bankr. S.D.N.Y. 2010), the U.S. Bankruptcy Court for the Southern District of New York held that the ipso facto provisions of §§365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code barred a contractual reversal of priorities between noteholders and a swap counterparty that held competing interests in collateral under certain transaction documents relating to a swap agreement. Many large bankruptcy cases involve multiple debtors that may not all file on the same day, which was the case in Lehman Brothers. However, for purposes of the ipso facto clause, the court found that the operative bankruptcy filing triggering an automatic stay was not the later bankruptcy filing by the debtor-counterparty itself, but rather the earlier filing of the counterparty’s parent corporation “as credit support provider.”
The relevant facts of Lehman Brothers are as follows: In 2002, the predecessor to BNY Corporate Trustee Services Limited (BNY) entered into a principal trust deed with Dante Finance Public Limited Company (Dante), pursuant to which a multi-issuer secured-obligation program was established (the “Dante program”). Id. at 413. Under the Dante program, Saphir Finance Public Limited Company (Saphir), a special-purpose entity created by Lehman Brothers International (Europe), issued various series of credit-linked synthetic portfolio notes that were secured by collateral, which BNY held for the benefit of creditors of Saphir, including Perpetual Trustee Company Limited (Perpetual). Id.
Each series of notes was governed by a supplemental trust deed that, in turn, referenced a particular swap agreement. Id. Lehman Brothers Special Financing Inc. (LBSF), which would later be a chapter 11 debtor in New York, was a party to certain of the swap agreements with Dante. Lehman Brothers Holdings Inc. (LBHI), the ultimate parent company of LBSF, acted as credit support provider for LBSF’s payment obligations under the swap agreements. Id.
The notes and accompanying documents (collectively, the “transaction documents”) were governed by and were to be construed under English law. Id. at 414. The transaction documents provided that LBSF had rights in the collateral that had priority over the rights of Perpetual (the “swap counterparty priority”). Id. at 413. However, the transaction documents also provided that, if an event of default occurred on the part of LBSF under a swap agreement, a reversal of priorities would take place such that Perpetual would then be entitled to priority over amounts otherwise payable to LBSF (the “noteholder priority”). Id. One of the specified events of default under the swap agreements was the bankruptcy filing by any party. Id.
On Sept. 15, 2008, LBHI filed a voluntary chapter 11 petition in New York. Id. LBSF commenced its own voluntary chapter 11 case on Oct. 3, 2008. Id. Perpetual thereafter sought priority payment under the transaction documents since the bankruptcy filing was an event of default under the swap agreements. Id. at 411. Saphir sent notices to LBSF terminating the swap agreements, designating that: (1) LBSF’s filing of a chapter 11 petition was an event of default and (2) Dec. 1, 2008, was the early termination date under §6(a) of each ISDA master agreement. Id. at 413-14.
Perpetual commenced suit against BNY in the English High Court of Justice, Chancery Division seeking a determination regarding the noteholder priority under the swap agreements. Id. at 410. LBSF intervened in the English litigation. Id. at 411.
After a trial, the English High Court issued a judgment holding that LBSF’s interest in the collateral securing the swap agreements was “always limited and conditional” and that payment pursuant to the noteholder priority “did not violate the so-called ‘anti-deprivation principle’ under English law.”[1] The English Court found that the noteholder priority became effective on Sept. 15, 2009, the date on which LBHI, the credit-support provider for LBSF’s payment obligations under each swap agreement, filed for chapter 11 protection. Id. LBSF appealed the English High Court’s judgment to the Court of Appeal, Civil Division, which affirmed the judgment of the High Court. Id. at 412.
On May 20, 2009, during the pendency of the English litigation, LBSF filed an adversary proceeding against BNY in bankruptcy court seeking a declaratory judgment that the provisions in the swap agreements that modified LBSF’s payment priority upon an event of default constituted unenforceable ipso facto clauses, and that any action to modify LBSF’s right to priority as a result of its bankruptcy filing violated the automatic stay. Id. at 411. Both parties filed motions for summary judgment. Id. at 411-12.
The starting point for the bankruptcy court’s analysis was §365(e)(1) of the Bankruptcy Code, which bars enforcement of provisions in a contract that would cause the contract or any right or obligation thereunder, to be “terminated or modified” solely because of a provision in such contract that is conditioned on, among other things, “the commencement of a case” under title 11. 11 U.S.C. § 365(e)(1); id. at 415. Similarly, the court looked at §541(c)(1)(B) of the Bankruptcy Code, which explains that an interest of the debtor in property becomes property of the estate notwithstanding any provision in an agreement, transfer instrument or applicable nonbankruptcy law that “that is conditioned on the...commencement of a case” under title 11. 11 U.S.C. § 541(c)(1)(B); id. at 415.
The court explained that “[t]he intriguing question presented is whether it is the bankruptcy filing of LBHI or the later filing of LBSF that is the relevant commencement of a case for purposes of invalidating the shifting of priorities under the Transaction Documents.” Id. at 415 (emphasis added). After finding that each of the transaction documents was executory, the court then turned to the application of the ipso facto provisions. See id. at 416.
First, the bankruptcy court dismissed BNY’s argument that the bankruptcy court was bound by the English decision. The court explained that “[t]he English Courts did not consider any provisions of the Bankruptcy Code in connection with their decisions” and declined to give preclusive effect to the judgments of the English Courts. Id. at 417.
BNY’s next argument was that the noteholder priority replaced the swap counterparty priority as of the date of LBHI’s bankruptcy, such that the property right claimed by LBSF already was lost before the date of commencement of the LBSF bankruptcy case. See id. at 414. In concluding that BNY’s position was “inconsistent with the structure of the transaction documents,” the court looked carefully at the documents at issue and explained that as of the LBSF petition date, the transaction documents required certain affirmative acts that were not yet taken in order for the modification of payment priority to be effective, and concluded that “LBSF held a valuable property interest in the Transaction Documents as of the LBSF Petition Date and, therefore, such interest is entitled to protection as part of the bankruptcy estate.” Id. at 418.
The bankruptcy court went on to explain that both §§365(e)(1) and 541(c)(1)(B) prohibit modification of a debtor’s rights because of a provision in an agreement conditioned on “the commencement of a case under this title.” Id. (emphasis in original). The court examined the legislative history of the words “a case” and concluded that “the provisions in the Transaction Documents purporting to modify LBSF’s right to a priority distribution solely as a result of a chapter 11 filing constitute unenforceable ipso facto clauses.” Id. at 420. The court stated that it was “convinced that the chapter 11 cases of LBHI and its affiliates is a singular event for purposes in interpreting this ipso facto language.” Id. However, the bankruptcy court was careful to limit its holding to “the situation presented by the sequential filings of LBHI and LBSF bankruptcy cases and confine its conclusions to the Debtors’ business structure and circumstances...the most complex and multi-faceted business ventures ever to seek the protection of chapter 11,” and added, “[e]veryone knows that together these filings constitute the largest business bankruptcy in history.” Id. at 420.
Next, the bankruptcy court dismissed BNY’s argument that the noteholder priority and subordination provision were enforceable as part of an integrated swap agreement that qualifies for protection under the “safe harbor” provisions of §560 of the Code. Id. at 414. The court found that the provisions at issue were not contained within qualifying swap agreements, explaining that “there is no reference at all to the Supplemental Trust Deeds, the Noteholder Priority provision or Condition 44 in the Swap Agreements themselves...it follows that the Noteholder Priority provision and Condition 44 do not fall under the protections set forth [in §560].” Id. at 421.
Finally, the bankruptcy court dismissed BNY’s argument that the noteholder priority and related provisions constituted subordination agreements that were found to be enforceable by the English courts under applicable English nonbankruptcy law. See id. at 421. The court explained that “BNY cannot overcome the shifting nature of the subordination that is being activated by reason of a bankruptcy filing...the shift in payment priority upon the commencement of a bankruptcy case renders unenforceable this aspect of the subordination agreement.” Id. at 421-22.
Lehman Brothers is important because it is the first case that holds that the automatic stay caused by the filing of a related debtor can invalidate an ipso facto clause in a contract of a related debtor. Hence, when there is a group of debtors, all making up an integrated entity, the filing of one debtor may trigger Bankruptcy Code protections for debtors that have not yet filed. Lehman Brothers is also instructive for the proposition that drafters should include in swap agreements relevant provisions contained in accompanying transaction documents that are integral to the functioning of a swap agreement when the counterparty is subject to U.S. law. Conversely, where possible, drafters of transactions governed by English Law should structure them with an English counterparty that has no possibility of being subject to the jurisdiction of the U.S. courts.
1. Id. at 411. The English anti-deprivation principle is a principle of U.K. insolvency law, pursuant to which a court may invalidate a contractual provision if the effect of the provision is to transfer an asset of an insolvent company to a third party, or otherwise deprive the company’s creditors of the benefit of the asset. It is very similar to the ipso facto notion present in the U.S. Bankruptcy Code.