Article courtesy of Margaret G. Parker-Yavuz (Akin Gump)
Lehman Bros. Special Fin. Inc. v. Branch Banking & Trust Co. (In re Lehman Bros. Holdings Inc.), 970 F.3d 91 (2d Cir. 2020)
Overview:
A Lehman Brothers affiliate that was party to a number of CDO transactions filed an adversary proceeding in bankruptcy court to recover approximately $1 billion that was distributed to noteholders after the Lehman Brothers Holdings Inc. bankruptcy triggered a default under swap agreements relating to the CDO transactions, alleging that unfavorable waterfall provisions in the transaction documents were unenforceable ipso facto clauses. The Second Circuit upheld the ruling of the district court that, even if the provisions were ipso facto clauses, they were nevertheless enforceable under section 560 of the Bankruptcy Code, which creates a safe harbor for the liquidation of swap agreements.
Full Summary:
Lehman Brothers Special Financing Inc. (“LBSF”), an indirect subsidiary of Lehman Brothers Holdings Inc. (“LBHI”), filed a voluntary petition for relief under Chapter 11 in October 2008, two weeks after LBHI began its Chapter 11 proceeding. Almost two years later, in September 2010, LBSF initiated an adversary proceeding in bankruptcy court against 250 noteholders, note issuers and trustees relating to 44 synthetic collateralized debt obligations (“CDOs”) that were structured, negotiated and marketed by LBSF and other Lehman affiliates. LBSF sought to recover approximately $1 billion that was distributed to noteholders after LBSF defaulted under the CDOs.
In the CDO transactions, LBSF and other Lehman affiliates formed a special purpose vehicle to act as issuer. Through the issuer, they marketed and sold notes to the noteholders pursuant to an indenture agreement. The issuer used the proceeds of the notes to purchase highly rated securities which, in turn, were pledged as collateral to secure the notes. The issuer used income generated by the collateral to make scheduled interest payments on the notes.
In each transaction, the issuer also entered into a swap agreement with LBSF, documented under an ISDA Master Agreement and related documents, under which the issuer sold a credit default swap to LBSF as protection against the potential default of certain “reference entities” or “reference obligations”. In exchange, LBSF made regular payments to the issuer which the issuer used to supplement the interest payments to the noteholders. LBSF’s obligations under the swap were guaranteed by LBHI. The swap agreements provided that, if any of the reference entities experienced certain “Credit Events”, the issuer could owe LBSF payment from the collateral.
The CDOs and the swaps were documented separately, but the indenture agreements and swap agreements referenced each other and the indenture trustees held the collateral in trust for both the noteholders and LBSF as secured parties. The indenture agreements provided that, upon the occurrence of an “Event of Default”, the trustees could cause the notes to be accelerated and trigger early termination of the swap. The trustees could then liquidate the collateral and distribute the proceeds according to waterfall provisions set out in the indenture agreements (the “Priority Provisions”). The swap agreements incorporated the Priority Provisions by reference. Under the Priority Provisions, LBSF had priority over the noteholders in certain circumstances but, in other cases (including a default by LBSF), LBSF’s right to payment was subordinated to that of the noteholders.
The bankruptcy filing of LBHI in September 2008 constituted an Event of Default under the swap agreements, with LBSF as the defaulting party. This default triggered the early termination of the swaps which, in turn, led to the liquidation of the collateral and the distribution of the collateral proceeds. Since LBSF was the defaulting party, the noteholders had priority with respect to the proceeds under the Priority Provisions. All of the proceeds were distributed to the noteholders, with none remaining for LBSF.
In September 2010, LBSF initiated an adversary proceeding against certain of the noteholders, trustees and issuers. It alleged, among other things, that the Priority Provisions were unenforceable ipso facto clauses (i.e., clauses that modify a debtor’s contractual rights solely because it filed for bankruptcy). The defendants filed a motion to dismiss, which the bankruptcy court granted. The bankruptcy court found that, although the Priority Provisions in a few of the CDO transactions were constructed in a way that made them ipso facto clauses, the Priority Provisions in all of the transactions were enforceable regardless of whether they were ipso facto clauses because they fell within the safe harbor under section 560 of the Bankruptcy Code, which exempts the termination and liquidation of swap agreements from the Code’s prohibition on the enforcement of ipso facto clauses. LBSF appealed, and the district court affirmed based on the section 560 safe harbor. The Second Circuit agreed with the district court and held that, even if the Priority Provisions were ipso facto clauses, the section 560 safe harbor permitted their enforcement.
The section 560 safe harbor was added to the Bankruptcy Code in 1990 to protect the stability of swap markets. Amendments passed by Congress in 2005 broadened the definition of “swap agreement” and clarified that a swap participant’s contractual right to liquidate and accelerate a swap agreement (in addition to its right to terminate the swap) are protected under the safe harbor. In its decision, the Second Circuit states that applicability of the safe harbor in this case turns on whether (1) the Priority Provisions are “swap agreements”, (2) the distribution of the collateral is a “liquidation”, and (3) the trustees were exercising a contractual right of a swap participant in liquidating the collateral and distributing the proceeds.
With respect to the first question – whether the Priority Provisions are “swap agreements” – the Second Circuit found that the Priority Provisions were incorporated by reference into the ISDA Master Agreements and, as a result, they are considered part of the swap agreements under the Bankruptcy Code’s definition of “swap agreement”. With respect to the second question – whether the distribution of the collateral is a “liquidation” – the court found that the distributions constituted a liquidation in that they were the exercise of a contractual right to liquidate collateral. With respect to the third question, the court found that, although the trustees themselves were not swap participants, in liquidating the collateral and distributing the proceeds they were acting on behalf of and exercising a contractual right of the issuers, who were swap participants.
