On 25 January 2010, the United States Bankruptcy Court handed down its much anticipated decision in relation to an action brought in that court by two Lehman Brothers entities (the Lehman entities) against BNY Corporate Trustee Services Limited (BNY) (the US Decision).
In contrast to an earlier decision of the English courts, the United States Bankruptcy Court held that so called "flip clauses" (clauses which provide that the payment obligations owed to two different creditors "flip" in priority following an event of default) are unenforceable. Flip clauses are routinely used in structured finance transactions, including Australian securitisation transactions, to prevent a defaulting swap counterparty from benefiting as a result of its own default at the expense of other creditors. In this regard the US Decision is highly relevant.
BNY is the security trustee in relation to a structured finance transaction involving a Lehman related SPV. Under the transaction documents relating to that transaction (which were governed by English law), BNY owed payment obligations to one of the Lehman entities, as a swap counterparty, and to Perpetual Trustee Company Limited (Perpetual), in relation to notes issued by that SPV.
The transaction documents contained a flip clause which provided that the payment obligations owed by BNY to one of the Lehman entities would take priority over those owed by BNY to Perpetual other than following an event of default under the relevant swap agreement, in which case the priority of those payment obligations would be reversed. Importantly, events of default under the relevant swap agreement included a bankruptcy filing in respect of either of the Lehman entities.
The High Court of England and Wales and the Court of Appeal have previously held that the flip clause in question was enforceable (the English Decisions).
Orders sought and jurisdiction
Notwithstanding that the relevant transaction documents were governed by English law, the Lehman entities brought an action in the United States Bankruptcy Court seeking, amongst other things, a declaratory judgement that:
"... the provisions in the Swap Agreements that modify LBSF's payment priority upon an event of default constitute unenforceable ipso facto clauses that violate Bankruptcy Code sections 365(c)(1) and 541(c)(1)(B), thereby enabling LBSF to retain its right to receive a priority payment under the Swap Agreements".
The United States Bankruptcy Court declined to be bound by the English Decisions to the extent that those decisions gave no consideration to the Bankruptcy Code and the provisions of the Bankruptcy Code provided greater protections than those available under English law.
Ipso facto clauses and decision
Simply put, an ipso facto clause is a contractual provision pursuant to which the filing of a bankruptcy petition triggers a modification or change in the position of the contracting parties.
Two sections of the Bankruptcy Code effectively render ipso facto clauses unenforceable by stipulating that:
rights under an executory contract may not be modified or terminated solely as a result of the operation of a provision under that contract which is triggered by a bankruptcy filing (section 365(e)); and
a debtor's interest in property becomes the property of its estate in bankruptcy irrespective of any provision in an agreement, which is triggered by a bankruptcy filing, that purports to modify or terminate that interest (section 541).
The United States Bankruptcy Court found that the flip clause in question fell within the scope of sections 365(e) and 541 of the Bankruptcy Code and, being an ipso facto clause, was therefore unenforceable.
While the English Decisions upheld the enforceability of flip clauses, the US Decision did not. The glaring inconsistency between the English Decisions and the US Decision leaves BNY (and others involved in structured finance transactions with a US counterparty or that are subject to US law) in a less than ideal situation.
Immediate implications of the US Decision appear to be that flip clauses will not be enforceable in circumstances where the relevant transaction has a US nexus (including where the documentation is subject to US law or where the counterparty is a US entity) and may thereby be subject to the jurisdiction of US courts.
It has already been suggested by various commentators and rating agencies that as a consequence of the US Decision, ratings assigned to existing and future structured finance transactions which have a US nexus may be limited to the rating of the swap counterparty. In the context of the Australian securitisation market, flip clauses are relatively recent (they have only become prevalent in the last 2 years or so) and, in asset-backed transactions, are generally limited to the subordination of break costs due to a swap counterparty following its default. In this context (i.e. given the likely low quantum of the payment which would otherwise be subordinated), calls to limit note ratings to the rating of the swap counterparty may be somewhat hyperbolic.
In the short term, the US Decision is likely to lead to forum shopping (i.e. future transactions may be structured to ensure that they do not involve a US nexus). In the longer term, we may see legislative action to expand the existing Bankruptcy Code safe harbour provisions relating to swap agreements (which protect from the operation of the Bankruptcy Code, provisions relating to the liquidation, acceleration and termination of swap agreements in bankruptcy) to include the operation of swap related flip clauses.
We understand that BNY will be appealing the US Decision and, accordingly, the full fallout of the US Decision is not yet entirely clear. It is fair to say, however, that the uncertainty generated by the decision will not bode well for the slowly recovering cross-border structured finance market which routinely employs flip clauses.