01 Sep 2016

The Courts flip-flopping (again) on the validity of “flip clauses”

By Karen O'Flynn, Flora Innes

Judge Chapman’s judgment is obviously a welcome development for participants in the structured capital markets, particularly those who transact regularly with US counterparties.

On 28 June 2016, the US Bankruptcy Court handed down an important judgment in Lehman Brothers Special Financing Inc. v. Bank of America National Association (Case No. 10-3547), summarily dismissing claims of Lehman Brother Special Financing Inc. (LBSF), which sought to claw back collateral proceeds in respect of more than 40 series of collateralised debt obligations (CDOs). Those proceeds were distributed to noteholders in late 2008, following the collapse of Lehman Brothers.

In dismissing LBSF’s complaints, Judge Chapman departed from a previous ruling of Judge Peck which found that “flip clauses” (ie. provisions in structured finance documents that reverse or “flip” the priority of payment obligations owed to swap counterparties on the one hand and noteholders on the other, following a specified event of default) were unenforceable ipso facto clauses as a matter of US law. In contrast, Judge Chapman ruled that not all flip clauses are ipso facto clauses; but, if they are, they are protected by the safe harbour provisions in the US Bankruptcy Code.

Litigation history

The validity of flip clauses has been the subject of much litigation in the context of Lehman Brothers’ bankruptcy, and across different jurisdictions.

  • In 2009, in the case of BNY, the High Court of England and Wales and the UK Court of Appeal both found that, as a matter of English law, the flip clause in question was effective and did not offend the anti-deprivation rule.[1]
  • In January 2010, Judge Peck of the US Bankruptcy Court found to the contrary, ruling that the same flip clause modified the rights of LBSF (to termination payments), following the bankruptcy filing by Lehman Brothers Holding Inc. (LBHI) (the ultimate parent company of the Lehman Brothers group) on 15 September 2008; and, accordingly, it was an impermissible ipso facto clause in contravention of sections 365(e)(1) and 541(c)(1) of the Code. Although LBSF only filed for bankruptcy on 3 October 2008, Judge Peck was of the view that LBSF’s filing and LBHI’s filing ought to be treated as a “singular event” which took place on the earlier petition date of 15 September 2008. In addition, Judge Peck found that the safe harbour provisions in section 560 of the Code (which protect the liquidation, termination and acceleration of swap agreements) did not extend to protect the distribution of proceeds resulting from the liquidation of swap agreements.[2]
  • Judge Peck’s decision in BNY was appealed, but the parties settled before the appeal was heard.
  • In July 2011, the UK Supreme Court upheld the lower English Court decisions and reaffirmed the effectiveness, at least under English law, of flip clauses used in structured finance transactions.[3]
  • Subsequent decisions of Judge Peck, for example, in Ballyrock[4] (2011) and Michigan Housing[5] (2013), affirmed his earlier rulings in BNY.

These conflicting decisions generated considerable uncertainty in the market over the enforceability of flip clauses.

In the insolvency context, parties involved in CDO transactions that were unwound in 2008 (including noteholders, issuers and trustees) were left with a significant exposure to claims from LBSF. Many were forced to litigate, mediate or otherwise resolve those claims with LBSF in the absence of any clear judicial guidance. It is estimated that, as a result of Judge Peck’s ruling in 2010, LBSF was able to recoup hundreds of millions of dollar through settlements with noteholders and other interested parties.

Against the backdrop of this litigation history, Judge Chapman’s ruling in June 2016 came as a welcomed development for many; but, arguably, it came six years too late.

The Adversary Proceeding

The Adversary Proceeding, in which Judge Chapman handed down her recent decision, is a defendant class action commenced by LBSF against 250 issuers, trustees and noteholders of 44 series of CDOs. The key allegations made by LBSF were that the flip clauses (or payment priority provisions) in the CDO transaction documents were unenforceable ipso facto clauses; accordingly, when Lehman Brothers filed for bankruptcy in 2008, the note trustees contravened the Code by complying with the flip clauses and distributing the proceeds of collateral underlying the CDOs to noteholders rather than to LBSF. On that basis (amongst others), LBSF claimed that those noteholders ought to disgorge the collateral proceeds they received (estimated at over USD 1 billion) and repay them to LBSF.

The Adversary Proceeding was commenced in September 2010 but was stayed, on multiple occasions, by the US Bankruptcy Court, which stay was only lifted in August 2014. In late 2015, certain defendants filed an omnibus motion to dismiss LBSF’s claims.

Judge Chapman’s decision

In granting the motion to dismiss, Judge Chapman found that:

1.         First, not all payment priority provisions are ipso facto clauses.

Where LBSF’s right to priority of payment (ahead of noteholders) was fixed at the outset as the default option, and that default priority only “flipped” in favour of noteholder priority upon satisfaction of certain conditions (e.g. where LBSF’s default triggered the early termination of the swap), these “Type 1” payment priority provisions were found to be ipso facto clauses, since they modified LBSF’s right to receive termination payments, a which right was held by LBSF prior to its bankruptcy filing.

On the other hand, “Type 2” payment priority provisions established no default priority position at the outset, but simply created a “toggle” between two potential payment waterfalls, one of which would become applicable upon early termination. As to which waterfall would apply, that depended entirely on the circumstance surrounding the early termination. As a result, prior to early termination, LBSF only held a contingent right to payment in one of those two payment waterfalls, and not a right to any senior priority position. “Type 2” clauses were therefore found not to be ipso facto clauses since they effected no modification of LBSF’s rights.

2.             Secondly, even assuming the opposite conclusion (that is, if “Type 2” priority provisions ipso facto modified LBSF’s rights), provided that the early termination of the relevant swaps occurred before the date of LBSF’s bankruptcy petition, then any modifications of LBSF’s rights would not contravene sections 365(e)(1), 541(c)(1) or 363(l) of the Code. In reaching this conclusion, Judge Chapman rejected the “singular event” theory articulated in BNY, and found that:

  • any modification of LBSF’s rights occurred upon early termination of the swaps and not at the time the collateral proceeds were distributed; and
  • even if early termination and/or distribution of proceeds took place after LBHI’s petition date (15 September 2008), so long as it occurred before LBSF’s petition date (3 October 2008), any modification of LBSF’s rights effected by the priority provisions would not have run afoul of the anti-ipso facto provisions because the modification would have been fully effective prior to “the commencement of the [debtor’s] case”.

3.             Lastly, and most importantly, Judge Chapman ruled that section 560 of the Code (also known as the safe harbour) protects the distributions by note trustees of collateral proceeds to noteholders, which were carried out as part of their exercise of the issuers’ rights to terminate and liquidate the swaps with LBSF. This protection extends to both Type 1 and Type 2 priority provisions.[6]

In overturning Judge Peck’s ruling in BNY on this particular issue, Judge Chapman repeatedly noted that, consistent with Congress’s intent in creating (and subsequently expanding) the safe harbour provisions to promote stability and efficiency of financial markets, those provisions are to be given a “broad and literal interpretation”. On that approach, Judge Chapman rejected LBSF’s argument that the word “liquidation” in section 560 ought to be limited to the termination of the swaps and no more. Rather, she found that the words “termination” and “liquidation” must be read to have distinct meanings and, in the present case, the “liquidation” of the swaps must therefore encompass both the liquidation of collateral as well as the distribution of its proceeds pursuant to the payment priority provisions.


Judge Chapman’s judgment is obviously a welcome development for participants in the structured capital markets, particularly those who transact regularly with US counterparties.

For those who were caught up in the Lehman Brothers’ collapse in 2008 (and are exposed to potential claims by LBSF), this latest decision goes some way towards dispelling the legal uncertainty that was created by Judge Peck’s decisions over the last 6 years. However, LBSF will no doubt appeal Judge Chapman’s decision and, in doing so, prolong the wait for a final resolution for all who are affected.

As for BNY and Ballyrock and many others with whom LBSF has already secured favourable settlements on the strength of Judge Peck’s decisions, this latest attempt by Judge Chapman to “right the wrong” (made by her predecessor) is but too little, too late. What it also means is that there are now two inconsistent rulings in the same bankruptcy case relating to the same issues in dispute. This divergence in outcome is unfair, to say the least, and has implications for third parties both in and outside of the US.

The “flip clause” litigation (which arose in the context Lehman Brothers’ bankruptcy) also highlights the importance of cross-border communication and cooperation between courts in different jurisdictions when dealing with the insolvency of multi-national corporate groups. Ultimately, where inter-court cooperation is lacking and the principle of comity is not observed, it is the creditors (wherever located) who suffer, whether by reason of protracted litigation, delays in distributions or substantial costs being thrown away as part of the process.

[1] Perpetual Trustee Company Limited v BNY Corporate Trustee Services Limited & Lehman Brothers Special Financing Inc. [2009] EWCA Civ 1160; [2009] EWCA Civ 1160.Back to article

[2]Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Inc., (Re: 09-01242 (JMP)), 25 January 2010.Back to article

[3] Belmont Park Investments Pty Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc [2011] UKSC 38.Back to article

[4]Lehman Bros. Special Fin. Inc. v. Ballyrock ABS CDO 2007-1 Ltd. (In re Lehman Bros. Holdings Inc.), 452 B.R. 31 (Bankr. S.D.N.Y. 2011) (JMP).Back to article

[5]Michigan State Housing Dev. Auth. v. Lehman Bros. Special Fin. Inc. (In re Lehman Bros. Holdings Inc.), 502 B.R. 383 (Bankr. S.D.N.Y. 2013) (JMP).Back to article

[6] Section 560 of the Code relevantly 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… shall not be stayed, avoided, or otherwise limited by operation of any provision of [the Code].Back to article


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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.