On August 11, 2020, the United States Court of Appeals for the Second Circuit affirmed lower court decisions rejecting Lehman Brothers Special Financing Inc.’s (“LBSF”) attempt to recover nearly $1 billion in payments to noteholders and enforcing certain Priority Provisions (defined below) that subordinated payments otherwise payable to LBSF under related swap transactions.
In its per curiam decision, the Court found that the Priority Provisions contained in collateralized debt obligation (“CDO”) indentures that were triggered by the 2008 bankruptcy filing of Lehman Brothers Holding Inc. (“LBHI”) were contractual rights whose enforcement was protected by the Bankruptcy Code safe harbor provisions applicable to swaps entered into in connection with those CDOs.
In rejecting LBSF’s arguments, the Second Circuit held that even if the Priority Provisions were ipso facto clauses, the termination of the transactions and distribution of proceeds of collateral were protected by the safe harbor for swap agreements contained in section 560 of the Bankruptcy Code.
By its ruling, the Second Circuit maintains its expansive view of safe harbor protections generally1 and (a) applies safe harbor protections to a swap transaction entered into in connection with a structured debt transaction; (b) broadly construes “liquidation” to include both the calculation of obligations and the distribution of collateral proceeds; (c) interprets the ability to effectively incorporate other agreements into a transaction by reference; and (d) endorses actions by entities exercising enforcement rights on behalf of safe harbor-protected parties.
I. Background
In the years preceding the Lehman bankruptcy cases, LBSF and its affiliates structured numerous synthetic CDOs, each of which consisted of: (1) a CDO transaction, in which a Lehman special purpose vehicle (the “Issuer”) marketed and sold notes to noteholders and used the proceeds to acquire highly rated securities to serve as collateral and generate income to make interest payments to the noteholders, and (2) a credit default swap between the Issuer and LBSF, pursuant to which LBSF would make regular payments to the Issuer and could be entitled to a payment from the Issuer in the event of a default of a reference entity or reference transaction.
A third-party trustee held the collateral in trust and, upon the occurrence of an event of default, was empowered to issue a termination notice, which would accelerate payment on the notes and trigger termination of the swap. LBSF as swap counterparty enjoyed payment priority over the noteholders under certain circumstances, but pursuant to certain payment priority provisions (the “Priority Provisions”), in the case of LBSF’s default, LBSF’s payment was subordinated to the noteholders’ payment.
On September 15, 2008, LBHI filed a voluntary petition for chapter 11 relief, triggering an LBSF default on the credit default swaps. The default caused the termination of the swaps and led to the liquidation of the CDO collateral and subsequent distributions of proceeds therefrom. LBSF itself filed for chapter 11 two weeks after LBHI’s filing. Because LBSF had defaulted, when the transactions were terminated and the collateral securing the transactions was liquidated, the Priority Provisions stated that noteholders should be paid ahead of LBSF, despite LBSF’s “in the money” position on the swap at the time the default occurred.
In 2010, LBSF commenced an adversary proceeding challenging the priority of payments to the noteholders under 44 such CDO transactions and related credit default swaps, asserting both bankruptcy law and state law causes of action claiming that swap amounts owed to LBSF should have priority. LBSF argued that the Priority Provisions in the indentures governing the CDOs, which caused LBSF’s swap claims to be subordinated to the defendant noteholders’ claims upon an LBSF default, should be deemed ipso facto provisions, the enforcement of which is generally barred by the Bankruptcy Code.
Five years later, the noteholder defendants filed a motion to dismiss LBSF’s claims, which Judge Chapman of the Bankruptcy Court for the Southern District of New York granted. The District Court for the Southern District of New York subsequently affirmed Judge Chapman’s decision.