In June 2016, Judge Chapman of the US Bankruptcy Court handed down a landmark decision in In re Lehman Bros. Holdings Inc., 553 B.R. 476 (Bankr S.D.N.Y. 2016), upholding the validity of “flip clauses” and departing from the ruling by Judge Peck in the BNY case[1] to the effect that such clauses were unenforceable by reason of the ipso facto prohibitions under US bankruptcy law.
Judge Chapman’s decision was the subject of an appeal by Lehman Brothers Special Financing Inc. (LBSF), and was recently affirmed by the US District Court in Lehman Brothers Special Financing Inc., (Appellant) v. Bank Of America National Association, et al. (Appellees) (17 Civ. 1224 (LGS)). Given the recent introduction of the ipso facto stay in Australia, it is instructive to consider the US Court’s reasoning behind its decision to reject the appeal and the lessons that could be learnt in Australia.
Ipso facto prohibition and safe harbour protection under the US Bankruptcy Code
Under the US Bankruptcy Code, ipso facto clauses are generally unenforceable. Section 365(e) of the Code provides 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 this title[.]"
However, section 560 of the Code provides a safe harbour protecting a swap participant’s right to unwind a swap transaction pursuant to an ipso facto clause that would otherwise be unenforceable. That section states 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 because of a condition of the kind specified in section 365(e)(1) of this title … shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court … in any proceeding under this title."
LBSF’s appeal to the US District Court
At issue in the appeal was the enforceability of certain priority provisions in the transaction documents underlying some 200 series of synthetic collateralised debt obligations (CDOs), which provisions effectively subordinated amounts payable to LBSF (in favour of CDO noteholders), on the early termination of credit default swaps backing those CDOs.
District Judge Schofield did not find it necessary to revisit the US Bankruptcy Court’s conclusion that the priority provisions were not ipso facto clauses (that conclusion was reached on the basis that the priority provisions did not modify LBSF's rights due to its bankruptcy case, but simply specified which payment waterfall would apply in the event of an early termination). Instead, Judge Schofield focused on the safe harbour protection for swap agreements under section 560 of the Bankruptcy Code and its application to the priority provisions in question.
Scope of the safe harbour protection under section 560
The District Court found that, even assuming the priority provisions were ipso facto clauses which contravened section 365(e)(1) of the Code, they were nevertheless protected by the safe harbour provision under section 560. It follows that the distributions of collateral by the note trustees in accordance the priority provisions were protected and noteholders were properly paid ahead of LBSF.
In reaching that conclusion, Judge Schofield found that:
- when interpreting section 560 of the Code, it is important to construe the words of the section in their statutory context, including their legislative history. In this case, the legislative history of section 560 confirmed that its purpose was to protect securities markets from the uncertainties and disruptive effects associated with the risk of swap agreements not being honoured in bankruptcy. In light of that legislative purpose, the most sensible reading of section 560 is that it applies to the distributions of collateral in the present case – ie. enforcement of the priority provisions was the “exercise of [a] contractual right… to cause the liquidation [or] termination” of the swap component of the CDO transactions;
- further, the text of the safe harbour must be interpreted based on its plain meaning. Here, the dictionaries define the word “liquidate” to mean bringing an undertaking to an end and paying or distributing its assets. In light of that, the Court rejected LBSF’s assertion that that word “liquidation” as used in section 560 meant only the calculation of amounts owed upon the termination of a swap, and did not include the actual disbursement of those amounts under the priority provisions – such an interpretation limits itself to one definition of “liquidation” to the exclusion of others that are more fitting in this context. LBSF’s interpretation was also found to be nonsensible because it would nullify any protection which section 560 provides to swap agreements – mere calculations of amounts owed provides no security to swap participants if they are not also entitled to collect those debts; and
- although section 560 applies only to “[t]he exercise of [a] contractual right of [a] swap participant or financial participant to cause the liquidation… of one or more swap agreements”, it does not require the relevant right to be exercised by the swap participant or financial participant. Thus, in the present case, although the swaps were terminated and the priority provisions were enforced by the note trustees (which might not themselves be swap participants or financial participants), such termination and enforcement were nonetheless an exercise of a right of the issuers (which had outstanding swap agreements with LBSF at the time of the latter’s bankruptcy and were therefore “swap participants” for the purposes of section 560).
Exemptions from the ipso facto stay: lessons for Australia
In September last year, the Commonwealth Parliament in Australia passed the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth) which, starting from 1 July 2018, will impose a statutory stay on the enforcement of ipso facto rights in contracts entered into on or after that date against a company that is subject to receivership, voluntary administration or a scheme of arrangement.
There are a number of carve-outs from that statutory stay on enforcement, including an exemption of contracts that are protected under the Payments Systems and Netting Act 1998 (Cth). As regards other security arrangements (including swap agreements), the Parliament has left it open for the Government to make regulations to prescribe the specific types of contracts, agreements or arrangements that are to be exempted from the stay. In addition, the Minister may, by legislative instrument, declare specific rights to be exempted either generally or in specified circumstances. To date, no regulations or Ministerial declarations have been released.
In light of the multiplicity of litigation in the US concerning the meaning and scope of the safe harbour under section 560 of the US Bankruptcy Code, it would be prudent for the Australian Government and the Minister to express in the clearest possible terms any exemptions from the ipso facto stay, in order to avoid similar lawsuits in this country.
The risk of the parties disputing the nature of a contractual right (for example, the right to liquidate a swap agreement), and whether it falls within the scope of the relevant exemption, is particularly relevant to any exemptions which may be prescribed by a Ministerial declaration, given that such exemptions are capable of being drafted by reference to specific rights and specific circumstances.
As regards exemptions to be prescribed by regulations, it appears that the regulations may only specify the “kind of contract, agreement or arrangement” to which the stay does not apply, and all “rights contained in” the specified kind of contract, agreement or arrangement will be exempted from the stay.[2] It follows that a dispute about the nature of a particular contractual right (and whether that particular right falls within the language of the exemption) may be less likely to arise.
However, there may still be disputes about the definitions of the specified “contract, agreement or arrangement” (for example, “swap agreements” and “netting contracts”) and whether a particular right is “contained in” one of those contracts. In the case of Lehman Brothers, some of the priority provisions were contained in the note trust deeds/indentures rather than the swap agreements themselves. One argument raised by LBSF was that the note trust deeds/indentures were not themselves “swap agreements” and, as such, section 560 of the Bankruptcy Code does not apply. That argument ultimately failed because the relevant swap agreements expressly incorporated the priority provisions from the note trust deed/indentures and, in any event, section 560 of the Bankruptcy Code does not, in terms, require that a particular right be provided for by or under a swap agreement. The outcome may be different in Australia where the legislation specifically requires the exempted right to be “contained in” the prescribed contract.
Another issue which may arise is, where an exempted contract contains a right that is not typically included in such a contract (for example, where a swap agreement includes a right for one of the contractual parties to terminate an unrelated supply agreement), how the Court would construe the scope of the exemption and its application to such a contractual right. Notably, the anti-avoidance provisions are included in the stay provisions themselves (eg. the proposed section 415D(1)(f)), and not in the provisions for the relevant exemptions (eg. the proposed section 415D(6)(b) - which provides that subsection 415D(1) does not apply to the contractual right in question if the right is contained in the type of contract prescribed by the regulations). In other words, the anti-avoidance provisions are seemingly subject to the exemption provisions. It will be interesting to see how the Courts deal with any attempts to exploit this potential loophole.
[1] Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Inc., (Re: 09-01242 (JMP)), 25 January 2010. Back to article
[2] See for example the proposed section 415D(6)(b)(i) to be inserted by the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 in the Corporations Act. Back to article