Client Alerts

Flip Flop: Safe Harbor Sinks Lehman Appeal

Client Alerts | April 5, 2018

A New York district court has affirmed, on appeal, the dismissal of an attempt by the Lehman Brothers estate to unwind payments made in connection with a series of CDO structures. The decision, Lehman Brothers Special Financing Inc. v. Bank of America N.A. (In re Lehman Brothers Holdings, Inc.), marks the second time that a court has rejected Lehman’s position that the documentation used in those CDO structures used an impermissible “flip clause.”

The decision demonstrates the continued vitality of the Bankruptcy Code’s securities safe harbors notwithstanding the Supreme Court’s recent Merit Management decision (discussed in our recent alert). The decision also provides reassurance to investors that the CDO structures used by Lehman should not be vulnerable to bankruptcy attack in other cases.


The litigation concerned 44 synthetic collateralized debt obligation (CDO) transactions set up by Lehman and marketed by Lehman to investors who were interested in taking synthetic long positions on credit default swaps opposite Lehman’s LBSF subsidiary. The investors bought notes issued by trusts established by Lehman, and the indenture trustees invested the note proceeds in securities to be held as collateral. The transaction documents provided that the collateral would be held and used to make payments under the swap agreements unless there was a termination event. The Lehman parent (LBHI) provided credit enhancement.

The transaction documents contained priority provisions that specified different waterfalls following a default depending upon who was the defaulting party. If there was a default by the noteholders or the trusts the collateral would be liquidated and paid to Lehman ahead of the noteholders. If there was a default by LBHI or LBSF the collateral would be liquidated and paid to the noteholders ahead of Lehman.
When LBHI (but not LBSF) filed for bankruptcy the indenture trustees terminated the swap agreements, liquidated the collateral and after paying expenses paid the balance of the proceeds to the noteholders. There was nothing left for Lehman.

After LBSF also filed for bankruptcy, Lehman brought several suits against noteholders from those CDOs, generally alleging that the payment waterfalls were based on “flip clauses” that were unenforceable ipso facto clauses. [1] The noteholder defendants [2] filed a motion to dismiss the complaint.

Bankruptcy Court decision

The Bankruptcy Court granted the motion and dismissed Lehman’s complaint against the moving noteholders in a decision dated June 28, 2016. The decision rested upon three independent bases. First, the Bankruptcy Court found that, for most of the relevant CDO structures, the contractual provisions regarding priority of payment were not “flip clauses,” as argued by Lehman, because no “flip” occurred. Second, the Bankruptcy Court found that even had a “flip” occurred, it would not have violated the ipso facto prohibitions because those prohibitions do not apply to pre-petition events, and the termination of the swaps agreements occurred before LBSF filed for bankruptcy. Third, the Bankruptcy Court found that the transactions were protected by the safe harbor of section 560, which provides an exception to the ipso facto prohibitions for “the exercise of a contractual right of any swap participant or financial participant to cause the liquidation, termination or acceleration” of a swap agreement.[3]

District Court Decision

Lehman appealed the decision to the District Court, which affirmed the Bankruptcy Court’s decision on March 18, 2018. The District Court opinion is based solely upon the safe harbor, and neither adopted nor rejected the other two legs of the Bankruptcy Court decision.

Lehman urged the District Court to read the safe harbor narrowly. Lehman proffered two arguments for the inapplicability of the safe harbor: (1) that the trustees were not “swap participant[s] or financial participant[s]” and (2) that the payment of collateral proceeds to the noteholders was not a “liquidation, termination or acceleration” of a swap. Both arguments were rejected.

Lehman also argued that the Supreme Court’s recent Merit Management decision not only dictated a ruling in favor of clawback plaintiffs but also invalidated several recent decisions of the Second Circuit Court of Appeals such as Madoff and Tribune (discussed in our alerts here and here) that enforced safe harbor defenses and that had been cited by the defendants. The District Court, rejected Lehman’s positions, ruling that Lehman’s narrow interpretation was inconsistent with both the plain language of the statute and its legislative history.

The District Court further cited Merit Management in support of its decision. It quoted the Supreme Court as directing courts to “look to both the language [of a statute] itself and the specific context in which that language is used.” Based on the language of the safe harbor and context in which it is used the District Court found Lehman’s proposed narrow interpretation of the safe harbor to be “nonsensical.”

Looking forward

The Lehman decision suggests that courts will read the Merit Management decision narrowly. While Merit Management resolved the specific conduit issue in that case, it should not be read as a more general call to roll back safe harbor protections.

The Lehman decision should also provide general comfort to investors in other CDO structures. The solicitation materials that Lehman prepared for the CDO structures advised investors that the priority provisions at issue would be enforceable in a future bankruptcy. A decision in favor of Lehman would have the effect of allowing a party in Lehman’s position to use a bankruptcy to effect an early termination of swaps contracts at a propitious time – a feature that is not permitted under the express terms of the contracts.

Kleinberg Kaplan represents certain defendants in the Lehman adversary proceeding.

[1] In general, an ipso facto clause is a provision of a contract that creates a default or forfeiture or a modification of the debtor’s rights automatically upon the filing of a bankruptcy petition. Such clauses are generally invalidated under the Bankruptcy Code.
[2] The Pyxis CDO structure was sufficiently different from the rest of the structures discussed above that Pyxis defendants did not join in the motion to dismiss. Litigation with regard to the Pyxis structure is proceeding separately.
[3]The section 560 safe harbor is related to, but not identical to, the section 546(e) safe harbor discussed in our recent alert.