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1 For more information, please contact: Michael Venditto Andrea Pincus Lehman Tries to Flip its Flop on the Flip Clause Introduction This September will mark the ninth anniversary of the filing of the Lehman Brothers bankruptcy cases in the United States. 1 These years have produced some controversial decisions, perhaps none more so than one rendered in January 2010, in which U.S. Bankruptcy Judge James Peck ruled the U.S. Bankruptcy Code protected a debtor from the operation of a clause that changed the waterfall of distributions in a CDO transaction, triggered not by its own bankruptcy filing but by the prior bankruptcy of a related entity. 2 That unprecedented ruling substantially expanding the scope of bankruptcy relief to upend agreed terms before a party to the agreement has even filed for bankruptcy protection - has never been considered by a higher court in the U.S. 3 But Lehman s decennial may finally provide a much anticipated review. At stake are hundreds of millions of dollars of claims which Lehman has been pursuing for years against scores of counterparties. On June 28, 2016, Judge Shelly Chapman, who has been presiding over the Lehman cases since Judge Peck s retirement, issued a lengthy decision rejecting the rationale of her predecessor, which helped dispel some of the uncertainty that the BNY decision generated in structured-finance markets. 4 Judge Chapman ruled that many of the CDOs transactions were structured in a way that their priority provisions were not ipso facto clauses 5 and those that 1 The first Lehman Brothers filings in the United States Bankruptcy Court were made on September 15, In re Lehman Brothers Holdings Inc., Debtor. (Bankr. S.D.N.Y. Case No ). 2 Lehman Bros. Special Fin. Inc. v. BNY Corp. Trustee Servs. Ltd., (In re Lehman Brothers Holdings Inc., et al.), 422 B.R. 407 (Bankr. S.D.N.Y. 2010) ( BNY ). 3 In July 2011, the Supreme Court of England, reviewing on appeal the same flip clause provisions following very contentious litigation between Lehman and noteholders in the CDO, concluded thatt the flip clause was enforceable as drafted and affirmed the decisions of the Court of Appeal and High Court below. See, Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd., [2011] UKSC July 2011). 4 Lehman Bros. Spec. Fin. Inc. v. Bank of America Nat l Assoc., et al. (In re Lehman Brothers Holdings Inc.), Adv. Pro. No (SCC), 2016 Bankr. LEXIS 2405 (Bankr. S.D.N.Y., June 28, 2016). 5 Ipso facto clauses are contractual provisions thatt take effect immediately upon the filing of a bankruptcy petition. Under several provisions of the U.S. Bankruptcy Code, these clauses are unenforceable because they allow for the modification or terminationn of contracts with the resulting loss of the debtor s contractual rights. 1

2 were ipso facto clauses were protected by the safe harbor provisions of the Bankruptcy Code, which exempt from the automatic stay actions by non-debtor counterparties to terminate, accelerate or liquidate qualified financial contracts, and to foreclose on collateral under the same transactions. In January, Judge Chapman certified her order for appeal, which has allowed Lehman to seek a review of the ruling. Lehman and the defendants (which include noteholders, issuers and indenture trustees) filed their initial briefs. The appeal is pending in the District Court in New York before Judge Lorna G. Schofield. 6 Several securitiess industry groups also have filed briefs in the appellate case urging affirmance of Judge Chapman s decision. 7 Background: The Flip Clause Litigation Judge Chapman s decision was renderedd in a proceeding in which Lehman sought to recover distributions made by the indenture trustees for the special-purpose entities ( Issuers ) in 44 synthetic CDOs that LBHI had structured and marketed before its bankruptcy filing. On September 14, 2010, Lehman Brothers Special Financing Inc. ( LBSF ), an indirect subsidiary of Lehman Brothers Holdings Inc. ( LBHI ), commenced the adversary proceeding (a lawsuit under the Bankruptcy Court s jurisdiction) against 250 noteholders, Issuers and indenture trustees seeking to recover approximately $1 billion that had been distributed after the commencement of the Lehman Brothers chapter 111 proceedings. LBSF claimed that the funds should have been paid to it, as the counterparty under credit default swaps (the Swaps ) with the Issuers, notwithstanding certain contractual provisions to the contrary. In each of these CDOs, the transaction documents included waterfall provisions governing the payment priority upon the liquidation of collateral held by the trustees following termination of 6 Lehman Brothers Special Financing Inc. v. Bank of America National Association, et al., Case Number 1:17 cv 01224, U.S. District Court for the Southern District of New York (LGS). 7 On June 16, 2017, the Securities Industry and Financial Markets Association ( SIFMA ) and the International Swaps and Derivatives Association ( ISDA ) filed a joint friend of the court brief amicus curia arguing that enforcement of the contractual priority of payment provisions would send a clear message to the markets that they may rely on the Bankruptcy Code safe harbor provisions. See, Brief Of Amici Curiae Securities Industry And Financial Markets Association And International Swaps And Derivatives Association, Inc. In Support Of Defendants Appellees And Affirmance, Case 1:17 cv LGS, Document 87 (06/16/17)( Amici Curiae Brief ). The Structured Finance Industry Group Inc. ( SFIG ) separately filed its own amicus brief. 2

3 the Swap (the Priority Provisions ). Critically, in the event that the termination of the Swap was caused by the default of LBSF or LBHI as its credit support provider, the Priority Provisions moved LBSF down the payment waterfall - below the noteholders in the CDOs. Relying on Judge Peck s 2010 decision in the BNY case, which involved substantially similar provisions, LBSF contended thatt the Priority Provisions were ipso facto clauses that were renderedd unenforceable after its bankruptcy filing by sections 365(e)(1), 541(e)(1), and 363(l) of the Bankruptcy Code. At Lehman s request, the litigation was stayed for five (5) years while it pursued mediation with the noteholders. However, in late 2015 Judge Chapman permitted the defendants to jointly file an omnibus dismissal motion. The noteholders and indenture trustees then moved to dismiss the complaint, arguingg that (i) the Priority Provisions were not unenforceable ipso facto clauses becausee they did not modify LBSF s rights as a consequence of its bankruptcy, and (ii) even if the Priority Provisions were ipso facto clauses, the distributions were protected by the financial safe harbor provisions of the Bankruptcy Code. The June 2016 Decision In ruling on the omnibus dismissal motion, Judge Chapman distinguished the Priority Provisions according to the operation of the underlying transaction documents. In so-called Type 1 transactions, if LBSF was in-the-money, LBSF had an automatic right to receive its Swap termination payment ahead of payments to the noteholders, but such priority was lost when LBSF defaulted on the Swaps. The Court held that the waterfall in Type 1 transactions modifiedd LBSF s rights and, therefore, these were unenforcea ble ipso facto clauses. The Type 2 transactions had Priority Provisions that did not establish a default priority if LBSF was in-the-money. Instead, the priority was not fixed until the Swap was actually terminated. LBSF s payment priority would only arise upon early termination of the Swap if certain conditions existed. One of those conditions was that early termination was not the result of LBSF s default under the Swap. In the Type 2 transactions, the early termination of the Swap was the result of LBSF s default. In these transactions, LBSF never had a payment priority and therefore Judge Chapman held that the Priority Provisions were not unenforceable ipso facto clauses. The court also held that even assuming the opposite conclusion with respect to the Priority Provisions in Type 2 transactions, any such 3

4 modification occurred before the commencement of LBSF s bankruptcy case when LBHI as guarantor filed for bankruptcy protection and created a default under the Swaps attributable to LBSF. Therefore, the resulting modifications in the waterfall would not have violated the ipso facto provisions of sections 365(e), 541(e)(1), or 363(l) of the Bankruptcy Code. In reaching this conclusion Judge Chapman explicitly rejected the singular event theory that had been the lynchpin of Judge Peck s decision in BNY, where LBHI s and LBSF s separate insolvency filings were treated as a singular event such that any action to modify LBSF s place in the CDO waterfalls taken in the time between the two bankruptcy filings was deemed unenforceable. Instead, Judge Chapman ruled that a modification that occurred before the LBSF petition date is not prohibited by the automatic stay provisions found in sections 365(e)(1), 541(e)(1), and 363(l) of the Bankruptcy Code. Finally, the Bankruptcy Court held that even if any of the Priority Provisions were unenforceable ipso facto provisions, the safe harbor provisions in section 560 of the Bankruptcy Code protected the distributions to noteholders from clawback by LBHI. The enforcement of the Priority Provisions and the distributions to the noteholders constituted the exercise of a right to cause the liquidation, termination, or acceleration of a swap agreement; and, the enforcement of the Priority Provisions was a right of the Issuers, who meet the statutory definition of swap participants. The Bankruptcy Court therefore dismissed the clawback claims with prejudice. This interpretation of the safe harbors was consistent with the prevailing view among courts that the safe harbor provisions reflect a strong Congressional policy of safeguarding the financial markets from the disruptive effects of a counterparty s bankruptcy filing. See, e.g., In re Bernard L. Madoff Investment Securities LLC, 773 F.3d 411, 420 (2d Cir. 2014) ( the interpretation pressed by the Trustee risks the very sort of significant market disruption that Congress was concerned with ); Official Comm. of Unsecured Creditors of Quebecor World (U.S.A.) v. Am. Life Ins. Co. (In re Quebecor World (U.S.A.)), 719 F.3d 94, 1000 (2d Cir. 2013). As reflected in the amicus briefing submitted this month by the financial industry associationss SIFMA, ISDA and SFIG in support of the defendants position on appeal, Judge Chapman s decision reflects the financial market s understanding of these transactions and the operation of waterfalll provisionss embedded within these arm s length agreements. As SIFMA and ISDA stated in their joint amicus brief, SIFMA and ISDA are concerned about the disruption of 4

5 the market and the concomitant losses to investorss who will not receive what they bargained for if Lehman prevails on its appeal. 8 The decision also brought the enforcement of contractual provisions in these defaulted CDO transactions into line with the treatment of such transactions under English law. At the time that Judge Peck entered his ruling in 2010 in the BNY litigation, noteholders in those CDO structures pressed litigation in the English courts, all the way to the Supreme Court of England, seeking enforcemen nt of the waterfall flip provision and their rights to distributions of the collateral. Over LBSF s objections, and unencumbered by the automatic stay endemic to U.S. insolvency proceedings, the English courts consistently ruled in favour of the noteholders and found the contractually agreed waterfall flip to be enforceablee upon the default by LBSF (including the default by its credit support provider). Conclusion Judge Chapman s decision has been applauded by many as providing a glimmer of hope amidst the uncertainty that followed the BNY decision. While it was probably not her intention to do so, Judge Chapman s decision had the effect of finally bringing the enforcement of critical payment provisions in complex financial transactions in line with market expectations in both the U.S. and England, the two leading global financial centres. Whether her decision will be affirmed and provide an ongoing level of certainty to participants in the financial markets remains to be seen. Because the decision interpreting the Priority Provisions came from a bankruptcy judge on the same court as Judge Peck, and not as the result of an appeal to a higher court, it could not overturn the BNY decision. In her own words, Judge Chapman respectfully departs from some of Judge Peck s reasoning. Consequently, the uncertainty about the proper interpretation of waterfall flip provisions and the scope of the safe harbors has actually increased with two conflicting views from judges of equal authority on the same bench. Judge Schofield s decision on the pending appeal which may not come before year-end or early in 2018 may begin to dissipate the fog that has obscured the waterfall flip provisions and rendered the safe harbors less safe than Congress intended. But, a furtherr appeal of her decision from Judge Schofield up to the Second Circuit Court of Appeals could further delay a more definitive resolution. 8 Amici Curiae Brief at page 22. 5

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