Lehman Bankruptcy Court holds that CDO provision subordinating swap termination payments to Lehman is unenforceable
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USA January 26 2010 Yesterday, Judge Peck of the U.S. Bankruptcy Court for the Southern District of New York decided an issue of major importance in the bankruptcy of Lehman Brothers Special Financing (“LBSF”) and its affiliates. In this decision, Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd., Ch. 11 Case No. 08-13555. Adv. No. 09-01242 (Jan. 25, 2010), Judge Peck held that market-standard provisions in structured finance transactions that subordinate swap termination payments upon a swap counterparty default are not enforceable when the default is the bankruptcy of the counterparty or, as in this case, the ultimate holding company of the counterparty. This result is in direct conflict with the judgments of English courts regarding the very same provisions and generally throws into doubt the enforceability of these standard provisions in other structured finance transactions. If not overturned, this decision could also result in LBSF receiving billions of dollars from various CDOs that would otherwise be distributed to their noteholders.
The Subordination Provisions and LBSF’s Default
The collateral held by a CDO issuer generally secures both the noteholders and any swap counterparty. Commonly, the amounts payable to the swap counterparty take priority over the amounts payable to the noteholders, except for swap termination payments triggered by an event of default with respect to the swap counterparty, which are subordinated to amounts payable to noteholders.1
The CDOs at issue in this case contained these standard provisions relating to the priority of swap termination payments. The collateral document, a Trust Deed governed by English law, secured the issuer’s obligations to the noteholders and to LBSF, the swap counterparty. The Trust Deed also provided that, if the security was enforced against the collateral, the proceeds of the collateral would be used to pay the issuer’s obligations to LBSF as swap counterparty prior to the issuer’s obligations to the noteholders, except when LBSF is a defaulting party under the swap agreement. In the latter case, the proceeds would be applied to the issuer’s obligations to the noteholders prior to the issuer’s obligations to LBSF as swap counterparty.
On September 15, 2008, Lehman Brothers Holdings Inc. (“LBHI”) filed a bankruptcy petition under Chapter 11 of the U.S. Bankruptcy Code. Because LBHI was a “credit support provider” of LBSF, this filing constituted an event of default with respect to LBSF under the swap agreement between LBSF and the CDO issuer. On October 3, 2008, LBSF also filed a bankruptcy petition under Chapter 11, which also constituted an event of default under the swap agreement. On December 1, 2008, the CDO issuer sent a notice to LBSF terminating the swap agreement, citing LBSF’s bankruptcy filing as the relevant event of default. LBSF estimated that approximately AUD 90 million was due to it in connection with the swap termination; however, if the subordination provisions were enforceable, all of the proceeds of the CDO collateral would be used to pay the noteholders and no payment would be made to LBSF.
The English Decisions
The meaning and enforceability under English law of the subordination provisions in the Trust Deed have been considered by the English High Court of Justice and Court of Appeal, Civil Division. In a unanimous decision last November, the Court of Appeal affirmed the High Court’s determination that the subordination provisions were valid and enforceable under English law. The Court of Appeal specifically held that (i) LBHI’s bankruptcy filing resulted in the noteholders’ interest in the collateral taking priority over LBSF as of LBHI’s September 15, 2008 bankruptcy filing and (ii) the subordination provisions did not violate the English-law “anti-deprivation” principle2 because they did not deprive LBSF of any right or interest in any property since “it had always been an agreed feature” of LBSF’s rights in the collateral that “LBSF had to rank behind, rather than ahead of [the noteholders]” in the event of a swap default with respect to LBSF.
The Bankruptcy Court Decision
Notwithstanding the decisions of the English courts, Judge Peck held that the subordination provisions in the Trust Deed were ipso facto clauses rendered unenforceable by sections 365(e)(1) and 541(c)(1)(B) of the U.S. Bankruptcy Code. In relevant part, these sections, respectively, provide that:
an executory contract . . . of the debtor may not be terminated or modified and any right or obligation under such contract . . . may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract . . . that is conditioned on . . . the commencement of a case under [the Bankruptcy Code]; [and]
an interest of the debtor in property becomes property of the estate . . . notwithstanding any provision in an agreement . . . that is conditioned on . . . the commencement of a case under this title . . . and that effects or gives an option to effect a forfeiture, modification or termination of the debtor’s interest in property.
Judge Peck interpreted the CDO transaction documents to provide that the subordination of LBSF’s interest in the collateral did not take effect until after the delivery of the swap termination notices on December 1, 2008 or (even later) when amounts were due to be paid in connection with the enforcement of the collateral security (notwithstanding the decision of the English courts that the subordination had occurred on September 15, 2008). On that basis, he concluded that the subordination provisions were unenforceable under sections 365(e)(1) and 541(c)(1)(B) because LBSF held a valuable property right as of the filing of LBSF’s bankruptcy petition on October 3, 2008 that could not then be modified.
Judge Peck did not stop there, however. He also held that, even if the English courts were right that the subordination of LBSF’s interest in the collateral was effective on the date of LBHI’s bankruptcy petition, the subordination provisions would still be unenforceable ipso facto clauses. Judge Peck noted that sections 365(e)(1) and 541(c)(1)(B) prohibit modifications of the debtor’s rights because of provisions conditioned on “the commencement of a case under [the Bankruptcy Code]” (emphasis added by Judge Peck). Because an early version and draft of these sections were limited to cases “by or against the debtor” or “concerning the debtor,” Judge Peck concluded that Congress rejected such limitations. Even though he recognized that no other court had construed “a case” in these sections to refer to a case not involving the debtor and that opening up these sections to cases filed by debtors other than the counterparty risks opening a “can of worms,” Judge Peck held that the chapter 11 bankruptcy cases of LBHI and its affiliates constituted a “singular event” for purposes of interpreting these sections3 and, therefore, provisions purporting to modify LBSF’s rights to a priority distribution solely as a result of LBHI’s bankruptcy filing also constitute ipso facto clauses rendered unenforceable under sections 365(e)(1) and 541(c)(1)(B).4
Judge Peck also considered and rejected three other arguments in favor of enforcing the Trust Deed’s subordination provisions:
Bankruptcy Code Section 560. Judge Peck concluded that the subordination provisions are not protected by the “swap agreement” safe harbor in Section 560 because (i) the subordination provisions (which were not mentioned in the ISDA master agreement, schedule or confirmations) do not comprise part of the swap agreements and (ii) Section 560 protects liquidation, termination and acceleration of swap agreements, not the alteration of rights as they then exist.
Bankruptcy Code Section 510(a). Under Section 510(a), a subordination agreement is enforceable in bankruptcy “to the same extent such agreement is enforceable under applicable nonbankruptcy law.” Judge Peck distinguished the subordination provisions at issue from subordination agreements that permanently establish lien or payment priorities and held that the shift in payment priority renders these subordination provisions unenforceable.
Commercial Expectations. In his final footnote, Judge Peck acknowledged that he is confounding legitimate commercial expectations: “The Court recognizes that there is an element of commercial expectation that underlies the subordination argument. LBSF was instrumental in the development and marketing of the complex financial structures that are now being reviewed from a bankruptcy perspective. The Court assumes that a bankruptcy affecting any of the Lehman entities was viewed as a highly remote contingency at the time that the Transaction Documents were being prepared. At that time, LBSF agreed to a subordination of its Swap Counterparty Priority in the hard-to-imagine event that it should be in default at some time in the future. Capital was committed with this concept embedded in the transaction. But the ipso facto protections of sections 365 and 541 of the Bankruptcy Code apply uniformly, regardless of prepetition market expectations. They exist and should be enforced to preserve property interests for the benefit of all creditor constituencies.”
Next Steps
Yesterday’s decision still leaves unresolved the disposition of the disputed collateral. Quite separate and apart from the possibility of an appeal, the CDO trustee is now the subject of competing decisions by the Bankruptcy Court for the Southern District of New York and the English courts. The collateral is held in a custody account in England and a deposit account in Australia by the CDO trustee, a company organized under English law with its principal place of business in London. The sole noteholder, who was not a party to the bankruptcy case, is organized under Australian law and is the beneficiary of the decision by the English courts upholding the enforceability of its priority interest in the disputed collateral. Judge Peck closed his opinion with a recognition that the situation “calls for the parties, [the Bankruptcy] Court and the English Courts to work in a coordinated and cooperative way to identify means to reconcile the conflicting judgments” and directed the parties to attend a status conference “for purposes of exploring means to harmonize the decisions of [the Bankruptcy] Court and the English Courts.”
Broader Implications
If not overturned, this case will provide a material benefit to LBSF’s estate. LBSF has estimated that the aggregate value of the termination amounts owed to it under transactions of this sort to be in excess of $8 billion (although LBSF may have reached settlements with some counterparties after this estimate was produced). To put this in perspective, these termination amounts are about 10% of the approximately $88 billion of claims reported to have been filed against LBSF. If not overturned, this case will have a corresponding adverse effect on the holders of CDO securities and other structured products where a Lehman debtor is the swap counterparty (although it is possible that this result is already fully or partially reflected in the market prices of these securities). This case creates significant uncertainty regarding the enforceability of market-standard subordination provisions and threatens the legitimate commercial expectations of CDO noteholders and other participants in structured finance transactions. This uncertainty may have an adverse impact on the ratings of existing CDO securities and other structured finance products. This case also creates significant uncertainty regarding which contractual provisions constitute unenforceable ipso facto clauses under the Bankruptcy Code. Judge Peck opened a “can of worms” by holding that the ipso facto protections could render unenforceable contractual provisions triggered by the commencement of “a case” involving a party other than the debtor, but did not adopt any principles limiting the cases to which these protections apply. He raised two possible principles (that multiple subsidiaries under common control are sufficiently related to permit the application of the ipso facto protections or that swap counterparties and their credit support providers are sufficiently related for the ipso facto protections to be triggered by the bankruptcy of either), but provided these principles only as examples and did not adopt either one.
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