Second Circuit Confirms “Flip Clauses” Protected by Bankruptcy Code’s Swap Safe Harbor

August 19, 2020

On August 11, 2020, the Second Circuit Court of Appeals affirmed lower court rulings1 that the safe harbor provisions of the Bankruptcy Code prevent the unwinding of certain swap payments based on the Bankruptcy Code’s general prohibition on ipso facto clauses.2 Specifically, the Second Circuit held that, in the context of certain synthetic collateralized debt obligations (“CDOs“), contractual “flip clause” provisions that alter payment priority based on a bankruptcy filing are enforceable. The Second Circuit’s decision resolves an issue that has been litigated for over a decade, with conflicting opinions in the Bankruptcy Courts for the Southern District of New York.3

Certain Lehman special purpose vehicles (“Issuers“) issued notes and used the proceeds to acquire high-rated securities (the “Collateral“). Each Issuer then entered into a swap agreement with Lehman Brothers Special Financing (“LBSF“), a subsidiary of Lehman Brothers Holdings Inc. (“LBHI“), pursuant to an ISDA Master Agreement. LBHI’s chapter 11 filing in 2008 was a default under the swap agreements. The indenture trustees for the notes (the “Trustees“) declared the default and accelerated the notes, triggering termination of the swaps and liquidation of the Collateral. This also triggered the flip clause that subordinated LBSF’s payment from the proceeds to that of the noteholders (the “Priority Provisions“).4 After the Trustees distributed proceeds of the Collateral to the noteholders, LBSF commenced adversary proceedings to rescind approximately $1 billion in payments alleging that the Priority Provisions were modified based solely on LBHI’s bankruptcy filing, and thus were impermissible ipso facto clauses.5

Generally, the Bankruptcy Code nullifies ipso facto clauses—which modify or terminate a contract upon a bankruptcy filing.6 However, the safe harbor provision of section 560 of the Bankruptcy Code (“Section 560“) provides an exemption to the prohibition of ipso facto clauses in the case of swap agreements. Specifically, in relevant part, the safe harbor provides that “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” due to an ipso facto clause “shall not be stayed, avoided, or otherwise limited” by the Bankruptcy Code.7

In the adversary proceedings, LBSF principally challenged the enforceability of the Priority Provisions that subordinated its payment priority upon default, arguing they were unenforceable ipso facto clauses that fell outside the bounds of any safe harbor.8 The main issues addressed by the Second Circuit were whether: (1) the Priority Provisions were included in the Bankruptcy Code’s definition of “swap agreements”; (2) the Trustees’ distribution of the Collateral was part of the “liquidation” of the Collateral; and (3) the Trustees’ liquidation and distribution of the Collateral meant that they had exercised a “contractual right of a[] swap participant.”9 In making its determinations, the Second Circuit largely adopted the “cogent reasoning” of the lower courts, which both agreed that Section 560 allowed the distribution authorized by the Priority Provisions.

First, the court dispensed with LBSF’s contention that the Priority Provisions did not fall within the definition of “swap agreements” because they were set forth in the indentures. Rather, the court found that because the Priority Provisions were referenced in the ISDA Master Agreement, they satisfied the definition of “swap agreements” under section 101 of the Bankruptcy Code, as that term is used in Section 560, because that definition includes “terms and conditions incorporated by reference in such agreement.”10

Next, the court considered whether distribution of the Collateral pursuant to the Priority Provisions constituted “liquidation” of a swap agreement under Section 560.11 The court found that, the term “liquidation,” according to its ordinary meaning and the specific context in which it is used in Section 560, “must include the disbursement of proceeds from the liquidated Collateral.”12 It found that this interpretation was “grounded in the statutory text and purpose of the section 560 safe harbor,” which was to “shield[] swap participants from some of the risks associated with a counterparty’s bankruptcy and enable[] them to unwind transactions.”13

Lastly, the court disagreed with LBSF’s contention that the Trustees’ involvement caused the swap termination and distribution of proceeds according to the Priority Provisions to fall outside of the Section 560 safe harbor because the Trustees were not “swap participants.” Instead, the panel found that the Trustees, by assignment, had received the rights of the Issuer and thereby “exercised a contractual right to effect liquidation when they distributed the proceeds of the sold Collateral. And, in doing so, the Trustees exercised the rights of a swap participant.”14

Given the lack of a Circuit court split, it isn’t likely that the Supreme Court will grant a petition for a writ of certiorari, were one to be filed. Therefore, the Second Circuit’s broad interpretation of Section 560 will bind lower courts in the Circuit for the foreseeable future. Seward & Kissel’s Corporate Restructuring & Bankruptcy Group will continue to monitor developments in this space. If you have questions related to the scope of the prohibition of ipso facto clauses or any safe harbor provisions, please don’t hesitate to reach out to the attorneys listed below, or your primary contact at S&K.


1   See Lehman Bros. Special Fin. Inc. v. Bank of Am. Nat’l Ass’n, 17 Civ. 1224, 2018 U.S. Dist. LEXIS 42548 (S.D.N.Y. Mar. 14, 2018) (“Lehman II“); Lehman Bros. Special Fin. Inc. v. Bank of Am. Nat’l Ass’n, 553 B.R. 476 (Bankr. S.D.N.Y. 2016) (Chapman, J.) (“Lehman I“).

2   Lehman Bros. Special Fin. Inc. v Branch Banking & Trust Co., No. 18-1079, 2020 U.S. App. LEXIS 25398 (2d Cir. Aug. 11, 2020) (“Lehman III“).

3   Compare Lehman I, with Lehman Bros. Special Fin. v. Ballyrock ABS CDO 2007-1 Ltd., 452 B.R. 31 (Bankr. S.D.N.Y. 2011) (Peck, J.).

4   Lehman III at 7-9.

5   Id. at 9.

6   See 11 U.S.C. §§ 363(l), 365(e)(1), 541(c)(1).

7   11 U.S.C. § 560.  This exemption was crafted “to protect the stability of swap markets and to ensure that swap markets are not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code.”  Lehman III at 15 (internal quotation marks and citations omitted).

8   Lehman III at 15.

9   Id. at 15-16.

10   Id. at 15-17.

11   Id. at 18.

12   Id.

13   Id. at 20, 21.

14   Id. at 25.