During the global financial crisis in 2008, Lehman Brothers Holdings Inc., which at the time was the nation’s fourth-largest investment bank, filed for Chapter 11 bankruptcy reorganization in what would become the largest bankruptcy proceeding in U.S. history. Over the course of a decade, Lehman Brothers and its bankrupt affiliates, including Lehman Brothers Special Financing Inc. (LBSF), filed multiple adversary proceedings. One of those proceedings was filed by LBSF in the Bankruptcy Court for the Southern District of New York against the 250 noteholders, the note issuers, and the trustees of certain synthetic collateralized debt obligations (CDO), and the proceeding eventually made its way to the U.S. Court of Appeals for the Second Circuit.
At the heart of LBSF’s claims were certain “Priority Provisions” that subordinated LBSF’s interests to those of the noteholders in the event Lehman Brothers filed for bankruptcy, which it did at a time when LBSF was allegedly “in the money” (i.e., when LBSF’s swap position had value). Specifically, when Lehman Brothers filed for bankruptcy, it triggered an event of default under the CDOs’ related swap and indenture agreements that authorized the trustees to liquidate the collateral securing the CDO notes and that gave the noteholders priority in payment of the proceeds over LBSF. When the trustees exercised their contractual power to liquidate the collateral and distribute the proceeds to the noteholders, LBSF became the last in line under the payment schedule and there was not enough money left at the bottom of the barrel when it was LBSF’s turn to collect. LBSF complained that the liquidation proceeds should have been paid to LBSF first, instead of to the noteholders, because the Priority Provisions in the complex financial instruments of its own creation were unenforceable ipso facto clauses. LBSF’s complaint led to a nearly decade-long dispute over whether the Priority Provisions were in fact ipso facto clauses – contractual clauses that are generally prohibited by the Bankruptcy Code because they modify a debtor’s contractual right solely because it petitioned for bankruptcy – and, if they were ipso facto clauses, whether they were rendered enforceable by virtue of the safe harbor provisions of section 560 of the Bankruptcy Code.
In its August 11, 2020 decision, the Second Circuit affirmed both the bankruptcy and district courts’ judgments interpreting section 560 in favor of the defendant noteholders, including Jackson Walker’s client. With the dismissal, LBSF failed to claw back roughly $1 billion in payments made to the noteholders in connection with the CDOs, as those payments were protected by the safe harbor.
In the opinion, the Second Circuit held “that, even if the Priority Provisions were ipso facto clauses, their enforcement was nevertheless permissible under the section 560 safe harbor.” Section 560 “exempts swap agreements from the prohibition of ipso facto clauses by protecting a swap participant’s contractual right to terminate, liquidate, or accelerate a transaction upon a counterparty’s bankruptcy.” In other words, as the Second Circuit put it, “this safe harbor permits swap participants to modify or terminate an executory contract solely because of the commencement of a bankruptcy case.” Since the Priority Provisions were part of the swap agreement component of the CDO transactions, the trustees’ liquidation of the CDO collateral and priority payment of the liquidation proceeds to the noteholders was permissible under the safe harbor. As the Second Circuit summarized:
“The Priority Provisions are incorporated by reference into the swap agreements and thus, for the purposes of section 560, are considered to be part of a swap agreement. The contractual right to liquidate included distributions made pursuant to Noteholder priority. The Trustees 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.”
For more information, view the decision in In re: Lehman Brothers Holdings Inc., 970 F.3d 91 (2d Cir. 2020), or the Law360 article “2nd Circ. Rejects Lehman’s $1B Clawback Effort.” Please note that a subscription is required to view the Law360 article.
The Jackson Walker team included Emilio B. Nicolas, J. Scott Rose, Jennifer F. Wertz, and Jorge A. Padilla.
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