"Flip Clause" Payments to Lehman Brothers Noteholders After Termination of Swap Agreement Safe Harbored in Bankruptcy

"Safe harbors" in the Bankruptcy Code designed to insulate non-debtor parties to financial contracts from the consequences that normally ensue when a counterparty files for bankruptcy have been the focus of a considerable amount of scrutiny as part of evolving developments in the pandemic-driven downturn. One of the most recent developments concerning this issue in the courts was the subject of a ruling handed down by the U.S. Court of Appeals for the Second Circuit in connection with the landmark chapter 11 cases of Lehman Brothers Holdings Inc. ("Lehman") and its affiliates. In In re Lehman Bros. Holdings Inc., 2020 WL 4590247 (2d Cir. Aug. 11, 2020), the Second Circuit affirmed lower court rulings that the Bankruptcy Code's safe harbor for the liquidation of swap agreements prevented a Lehman affiliate from recovering payments made to certain noteholders in accordance with a priority-altering "flip clause" triggered by Lehman's 2008 bankruptcy filing in agreements governing a collateralized debt obligation ("CDO") transaction. According to the court of appeals, even if the provisions were "ipso facto" clauses that are generally invalid in bankruptcy in other contexts, section 560 of the Bankruptcy Code creates an exception to this rule in connection with the liquidation of swap agreements. 

The Bankruptcy Code's Swap Agreement Safe Harbor

Over the past several decades, Congress has recognized the potentially devastating consequences that might ensue if the bankruptcy or insolvency of one financial firm were allowed to spread to other market participants, thereby threatening the stability of entire markets. Beginning in 1982, lawmakers formulated a series of changes to the Bankruptcy Code to create certain "safe harbors" to protect rights of termination and setoff under "securities contracts," "commodities contracts," and "forward contracts." Those changes were subsequently refined and expanded to cover "swap agreements," "repurchase agreements," and "master netting agreements" as part of a series of legislative developments, including the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA") and the Financial Netting Improvements Act of 2006.

These special protections are codified in, among other provisions, sections 555, 556, and 559 through 562 of the Bankruptcy Code. Without them, sections 362 and 365(e)(1) of the Bankruptcy Code would prevent a nondebtor party to a financial contract from taking immediate action to limit exposure occasioned by a bankruptcy filing by or against the counterparty. Lawmakers, however, recognized that financial markets can change significantly almost overnight and that nondebtor parties to certain types of complex financial transactions may incur heavy losses unless the transactions are promptly and finally closed out and resolved. Congress therefore exempted the kinds of financial contracts covered in the safe harbors from the automatic stay and section 365(e)(2) to insulate transactions under such contracts from avoidance unless the transactions were made with actual intent to defraud creditors.

For example, section 560 provides in relevant part as follows:

The exercise of any contractual right of any swap participant or financial 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) of this title or to offset or net out any termination values or payment amounts arising under or in connection with the termination, liquidation, or acceleration of one or more swap agreements shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title.

11 U.S.C. § 560. Added to the Bankruptcy Code in 1990, the provision was designed to protect the stability of swap markets and ensure that such markets are "not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code." H.R. Rep. No. 101-484, at 1 (1990). Section 560 was amended by BAPCPA to: (i) broaden the definition of "swap agreement" in section 101(53B) of the Bankruptcy Code to include many types of financial derivatives; and (ii) clarify that, in addition to a swap participant's contractual right to terminate a swap agreement, a participant's right to liquidate and accelerate a swap agreement is also protected.

Section 365(e)(1) of the Bankruptcy Code provides that, after a bankruptcy filing, an executory contract may not be terminated or modified, and any right under such a contract may not be terminated or modified:

solely because of a provision in such contract … that is conditioned on—(A) the insolvency or financial condition of the debtor at any time before the closing of the case; (B) the commencement of a case under this title; or (C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

11 U.S.C. § 365(e)(1). This general ban on the enforcement of "ipso facto" clauses in bankruptcy helps "deter the race of diligence of creditors to dismember the debtor before bankruptcy and promote equality of distribution." Merit Mgmt. Grp. v. FTI Consulting, Inc., 138 S. Ct. 883, 888 (2018). It is reinforced by various other provisions of the Bankruptcy Code. See 11 U.S.C. §§ 363(l) and 541(c)(1); see also Collier on Bankruptcy ¶ 362.03[5][a] (16th ed. 2020) ("[a]s property of the estate, the debtor's interests in [executory] contracts or [unexpired] leases are protected against termination or other interference that would have the effect of removing or hindering the debtor's rights in violation of section 362(a)(3)," which automatically stays any act to obtain possession of estate property or of property from the estate or to exercise control over estate property).

Section 560 carves out an exemption from this general rule in the case of swap agreements.


Lehman commenced the largest bankruptcy case in U.S. history when it filed for chapter 11 protection on September 15, 2008, in the Southern District of New York. Its indirect subsidiary, Lehman Brothers Special Financing Inc. ("LBSF"), filed a chapter 11 petition two weeks afterward.

Prior to filing for bankruptcy, LBSF entered into a synthetic CDO transaction involving the creation of a special purpose vehicle ("Issuer") to issue notes under an indenture ("Indenture"). The Issuer used the note proceeds to acquire securities that both generated income to pay interest on the notes and served as collateral under a credit default swap agreement ("CDS Agreement") between the Issuer and LBSF. In exchange for the credit protection under the CDS Agreement, LBSF made regular payments to the Issuer, which used the funds to supplement interest payments to noteholders. The CDO transaction and the CDS Agreement were documented separately, but the CDS Agreement and the Indenture referenced each other.

Upon the occurrence of an event of default under the Indenture, including a bankruptcy filing by Lehman, the Indenture trustee was empowered to issue a termination notice, which would accelerate payment due on the notes and trigger early termination of the swaps. The trustee could then liquidate the collateral and distribute the proceeds in accordance with the priority provisions in the Indenture. Those provisions included a "flip clause" providing that, in the event of a default by LBSF, LBSF's otherwise senior claim to the collateral proceeds would be subordinated to noteholder claims. 

LBSF defaulted under the Indenture when Lehman filed for bankruptcy, triggering early termination of the credit default swaps. The trustee distributed $1 billion from the proceeds of the sale of the collateral to noteholders, but the proceeds were insufficient to make any payment to LBSF.

In September 2010, LBSF commenced an adversary proceeding in the bankruptcy court against the noteholders and certain other defendants seeking to recover the $1 billion in payments under the theory that the flip clause in the Indenture that subordinated LBSF's claim upon Lehman's bankruptcy filing was an unenforceable ipso facto clause.

The bankruptcy court granted the defendants' motion to dismiss the complaint, ruling that, among other things, even if the flip clause was an ipso facto provision, it was nevertheless enforceable under the section 560 safe harbor for the termination and liquidation of swap agreements. After the district court affirmed on appeal, LBSF appealed to the Second Circuit.

The Second Circuit's Ruling

A three-judge panel of the Second Circuit affirmed the ruling below. Initially, the court rejected LBSF's argument that the ipso facto flip clause in the Indenture was unenforceable because the priority provisions were not part of a swap agreement covered by section 560. According to the Second Circuit, the Indenture's priority provisions were part of a swap agreement, and therefore safe harbored by section 560, because the CDS Agreement incorporated them by reference.

Next, the Second Circuit determined that, consistent with the purpose of section 560, the term "liquidation," as used in the provision, includes the disbursement of proceeds from liquidated collateral. Construing the term in this way, the court wrote, "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." According to the Second Circuit, the right to liquidate "would hardly protect swap counterparties if it merely sheltered their ability to determine amounts owed, but not to distribute the proceeds from the sold Collateral."

Finally, the Second Circuit rejected LBSF's argument that the distributions to the noteholders were not safe harbored because the Indenture trustee who terminated the swaps and distributed the proceeds of the collateral was not a "swap participant." The court explained that neither party disputed that the Issuer was a swap participant within the meaning of section 101(53C) of the Bankruptcy Code. In addition, the Indenture expressly granted the Indenture trustee all of the Issuer's contractual rights and obligations under the CDS Agreement, including the right to terminate and liquidate the swaps and the obligation to pay the noteholders and LBSF from the proceeds of the collateral. Moreover, the Second Circuit wrote, "section 560 requires the exercise of a contractual right 'of' any swap participant, not by one." 


Lehman is emblematic of a recent trend among many bankruptcy and appellate courts to apply the Bankruptcy Code's safe harbors for securities contracts broadly, consistent with lawmakers' intent to avoid disruptions in the securities and commodities markets.

To be sure, the U.S. Supreme Court tempered this approach when it held in Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), that another safe harbor—section 546(e) (shielding certain margin and settlement payments from avoidance except in cases of actual fraud)—does not protect transfers made through a "financial institution" to a third party, regardless of whether the financial institution had a beneficial interest in the transferred property, unless either the transferor or the transferee in the transaction sought to be avoided overall is itself a financial institution. However, after the Court suggested that the section 546(e) safe harbor might apply if the transferor is a "customer" of a financial institution, several lower courts have held precisely that, once again expanding the range of transactions that can qualify for protection. See, e.g., In re Tribune Co. Fraudulent Conveyance Litig., 2019 WL 1771786 (S.D.N.Y. Apr. 23, 2019); Holliday v. K Road Power Management, LLC (In re Boston Generating LLC), 2020 WL 3286207 (Bankr. S.D.N.Y. June 18, 2020).

Lehman, Merit, and other cases also suggest that, in determining whether a bankruptcy safe harbor applies, courts are inclined to look at the overall transaction in question as a whole, rather than the individual components separately.

Interestingly, the Second Circuit avoided addressing whether section 365(e) even applied in this case because the provision by its terms invalidates contract termination or modification triggered by the debtor's financial condition or bankruptcy filing, whereas the flip clause in Lehman was activated by Lehman's, rather than LBSF's, bankruptcy filing. The bankruptcy court, which was confronted with several different transactions involving similar flip clauses, recognized the potential for future disputes on this score, but ultimately focused on the "integrated enterprise" of the Lehman entities and the "exigent circumstances" surrounding the chapter 11 filings as the operative facts supporting a "singular event" theory. Given its conclusion that the flip clause was enforceable under section 560, the Second Circuit "assume[d] without deciding the Priority Provisions are ipso facto clauses."

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